Is SomnoMed (ASX:SOM) Using Debt Sensibly?

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 SomnoMed Limited (ASX:SOM) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for SomnoMed

How Much Debt Does SomnoMed Carry?

As you can see below, SomnoMed had AU$2.35m of debt at June 2021, down from AU$7.46m a year prior. But it also has AU$21.1m in cash to offset that, meaning it has AU$18.8m net cash.

How Healthy Is SomnoMed's Balance Sheet?

According to the last reported balance sheet, SomnoMed had liabilities of AU$16.2m due within 12 months, and liabilities of AU$7.81m due beyond 12 months. Offsetting these obligations, it had cash of AU$21.1m as well as receivables valued at AU$8.22m due within 12 months. So it actually has AU$5.33m more liquid assets than total liabilities.

This surplus suggests that SomnoMed has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, SomnoMed boasts net cash, so it's fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.

In the last year SomnoMed wasn't profitable at an EBIT level, but managed to grow its revenue by 9.4%, to AU$63m. We usually like to see faster growth from unprofitable companies, but each to their own.

So How Risky Is SomnoMed?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And in the last year SomnoMed had an earnings before interest and tax (EBIT) loss, truth be told. And over the same period it saw negative free cash outflow of AU$1.4m and booked a AU$1.1m accounting loss. Given it only has net cash of AU$18.8m, the company may need to raise more capital if it doesn't reach break-even soon. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. For riskier companies like SomnoMed I always like to keep an eye on whether insiders are buying or selling. So click here if you want to find out for yourself.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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