Is SomnoMed (ASX:SOM) Using Debt In A Risky Way?

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 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. Importantly, SomnoMed Limited (ASX:SOM) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for SomnoMed

What Is SomnoMed's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 SomnoMed had debt of AU$7.46m, up from AU$3.01m in one year. However, its balance sheet shows it holds AU$30.2m in cash, so it actually has AU$22.7m net cash.

How Healthy Is SomnoMed's Balance Sheet?

The latest balance sheet data shows that SomnoMed had liabilities of AU$18.8m due within a year, and liabilities of AU$9.08m falling due after that. Offsetting these obligations, it had cash of AU$30.2m as well as receivables valued at AU$6.13m due within 12 months. So it can boast AU$8.44m more liquid assets than total liabilities.

This short term liquidity is a sign that SomnoMed could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, SomnoMed boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine SomnoMed'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.

Over 12 months, SomnoMed made a loss at the EBIT level, and saw its revenue drop to AU$57m, which is a fall of 2.7%. That's not what we would hope to see.

So How Risky Is SomnoMed?

Although SomnoMed had an earnings before interest and tax (EBIT) loss over the last twelve months, it generated positive free cash flow of AU$3.0m. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. We'll feel more comfortable with the stock once EBIT is positive, given the lacklustre revenue growth. 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. Case in point: We've spotted 1 warning sign for SomnoMed you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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