We Think UCW (ASX:UCW) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies UCW Limited (ASX:UCW) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for UCW

What Is UCW's Net Debt?

The image below, which you can click on for greater detail, shows that UCW had debt of AU$3.25m at the end of June 2021, a reduction from AU$4.17m over a year. However, its balance sheet shows it holds AU$7.82m in cash, so it actually has AU$4.57m net cash.

A Look At UCW's Liabilities

We can see from the most recent balance sheet that UCW had liabilities of AU$11.4m falling due within a year, and liabilities of AU$17.4m due beyond that. Offsetting this, it had AU$7.82m in cash and AU$1.40m in receivables that were due within 12 months. So it has liabilities totalling AU$19.6m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of AU$15.3m, we think shareholders really should watch UCW's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that UCW has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

Shareholders should be aware that UCW's EBIT was down 70% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since UCW will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. UCW 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, UCW actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although UCW's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$4.57m. And it impressed us with free cash flow of AU$4.7m, being 281% of its EBIT. Despite its cash we think that UCW seems to struggle to grow its EBIT, so we are wary of the stock. 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. To that end, you should be aware of the 1 warning sign we've spotted with UCW .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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