Magontec (ASX:MGL) Seems To Use Debt Quite 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 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. We note that Magontec Limited (ASX:MGL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Magontec

How Much Debt Does Magontec Carry?

The image below, which you can click on for greater detail, shows that Magontec had debt of AU$3.39m at the end of June 2023, a reduction from AU$3.60m over a year. However, it does have AU$15.4m in cash offsetting this, leading to net cash of AU$12.0m.

How Strong Is Magontec's Balance Sheet?

We can see from the most recent balance sheet that Magontec had liabilities of AU$21.0m falling due within a year, and liabilities of AU$10.1m due beyond that. Offsetting these obligations, it had cash of AU$15.4m as well as receivables valued at AU$16.8m due within 12 months. So it actually has AU$1.02m more liquid assets than total liabilities.

This short term liquidity is a sign that Magontec could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Magontec has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Magontec if management cannot prevent a repeat of the 59% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Magontec 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, a company can only pay off debt with cold hard cash, not accounting profits. While Magontec has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Magontec produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing Up

While it is always sensible to investigate a company's debt, in this case Magontec has AU$12.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 70% of that EBIT to free cash flow, bringing in AU$11m. So we don't have any problem with Magontec's use of debt. 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 - Magontec has 3 warning signs we think you should be aware of.

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.

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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.