These 4 Measures Indicate That Valmec (ASX:VMX) Is Using Debt Extensively

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Valmec Limited (ASX:VMX) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. 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 Valmec

What Is Valmec's Net Debt?

As you can see below, at the end of December 2020, Valmec had AU$5.47m of debt, up from AU$2.44m a year ago. Click the image for more detail. But it also has AU$7.91m in cash to offset that, meaning it has AU$2.43m net cash.

A Look At Valmec's Liabilities

According to the last reported balance sheet, Valmec had liabilities of AU$26.9m due within 12 months, and liabilities of AU$7.87m due beyond 12 months. Offsetting this, it had AU$7.91m in cash and AU$35.8m in receivables that were due within 12 months. So it can boast AU$8.98m more liquid assets than total liabilities.

It's good to see that Valmec has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Valmec has more cash than debt is arguably a good indication that it can manage its debt safely.

Importantly, Valmec's EBIT fell a jaw-dropping 67% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Valmec's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Valmec 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. In the last three years, Valmec basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Valmec has net cash of AU$2.43m, as well as more liquid assets than liabilities. So although we see some areas for improvement, we're not too worried about Valmec's balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Valmec that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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