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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 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. We note that Countplus Limited (ASX:CUP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Countplus Carry?
As you can see below, Countplus had AU$1.19m of debt at December 2018, down from AU$4.23m a year prior. But it also has AU$11.4m in cash to offset that, meaning it has AU$10.2m net cash.
A Look At Countplus’s Liabilities
Zooming in on the latest balance sheet data, we can see that Countplus had liabilities of AU$10.9m due within 12 months and liabilities of AU$2.52m due beyond that. On the other hand, it had cash of AU$11.4m and AU$10.8m worth of receivables due within a year. So it can boast AU$8.74m more liquid assets than total liabilities.
This surplus suggests that Countplus has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Given that Countplus has more cash than debt, we’re pretty confident it can manage its debt safely.
Also good is that Countplus grew its EBIT at 12% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Countplus’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. Countplus 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. Over the last three years, Countplus actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
While it is always sensible to investigate a company’s debt, in this case Countplus has AU$10m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of AU$4.2m, being 135% of its EBIT. So is Countplus’s debt a risk? It doesn’t seem so to us. We’d be very excited to see if Countplus insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.