Is Babylon Pump & Power (ASX:BPP) Using Debt In A Risky Way?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Babylon Pump & Power Limited (ASX:BPP) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Babylon Pump & Power

How Much Debt Does Babylon Pump & Power Carry?

The image below, which you can click on for greater detail, shows that at December 2021 Babylon Pump & Power had debt of AU$17.3m, up from AU$11.9m in one year. However, it does have AU$1.53m in cash offsetting this, leading to net debt of about AU$15.8m.

A Look At Babylon Pump & Power's Liabilities

Zooming in on the latest balance sheet data, we can see that Babylon Pump & Power had liabilities of AU$18.5m due within 12 months and liabilities of AU$5.93m due beyond that. On the other hand, it had cash of AU$1.53m and AU$4.98m worth of receivables due within a year. So its liabilities total AU$17.9m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the AU$11.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Babylon Pump & Power would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Babylon Pump & Power's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Babylon Pump & Power wasn't profitable at an EBIT level, but managed to grow its revenue by 26%, to AU$25m. Shareholders probably have their fingers crossed that it can grow its way to profits.

Caveat Emptor

While we can certainly appreciate Babylon Pump & Power's revenue growth, its earnings before interest and tax (EBIT) loss is not ideal. Indeed, it lost a very considerable AU$4.3m at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of AU$5.6m over the last twelve months. That means it's on the risky side of things. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Babylon Pump & Power (at least 3 which are potentially serious) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.