Is Credit Intelligence (ASX:CI1) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Credit Intelligence Limited (ASX:CI1) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Credit Intelligence

What Is Credit Intelligence's Debt?

The image below, which you can click on for greater detail, shows that Credit Intelligence had debt of AU$2.03m at the end of June 2020, a reduction from AU$2.53m over a year. However, it does have AU$3.15m in cash offsetting this, leading to net cash of AU$1.13m.

How Strong Is Credit Intelligence's Balance Sheet?

We can see from the most recent balance sheet that Credit Intelligence had liabilities of AU$14.7m falling due within a year, and liabilities of AU$2.14m due beyond that. Offsetting this, it had AU$3.15m in cash and AU$12.4m in receivables that were due within 12 months. So it has liabilities totalling AU$1.27m more than its cash and near-term receivables, combined.

Of course, Credit Intelligence has a market capitalization of AU$30.2m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Credit Intelligence also has more cash than debt, so we're pretty confident it can manage its debt safely.

Even more impressive was the fact that Credit Intelligence grew its EBIT by 376% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Credit Intelligence's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Credit Intelligence may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Credit Intelligence produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Credit Intelligence has AU$1.13m in net cash. And it impressed us with its EBIT growth of 376% over the last year. So is Credit Intelligence's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 5 warning signs for Credit Intelligence that you should be aware of.

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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