Elmo Software (ASX:ELO) Has Debt But No Earnings; Should You Worry?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Elmo Software Limited (ASX:ELO) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Elmo Software

What Is Elmo Software's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Elmo Software had AU$30.0m of debt, an increase on none, over one year. However, its balance sheet shows it holds AU$81.9m in cash, so it actually has AU$51.9m net cash.

A Look At Elmo Software's Liabilities

We can see from the most recent balance sheet that Elmo Software had liabilities of AU$91.4m falling due within a year, and liabilities of AU$58.3m due beyond that. Offsetting this, it had AU$81.9m in cash and AU$13.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$53.9m.

Of course, Elmo Software has a market capitalization of AU$491.3m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Elmo Software also has more cash than debt, so we're pretty confident it can manage its debt safely. 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 Elmo Software'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 Elmo Software wasn't profitable at an EBIT level, but managed to grow its revenue by 38%, to AU$69m. Shareholders probably have their fingers crossed that it can grow its way to profits.

So How Risky Is Elmo Software?

By their very nature companies that are losing money are more risky than those with a long history of profitability. And the fact is that over the last twelve months Elmo Software lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of AU$30m and booked a AU$38m accounting loss. While this does make the company a bit risky, it's important to remember it has net cash of AU$51.9m. That kitty means the company can keep spending for growth for at least two years, at current rates. With very solid revenue growth in the last year, Elmo Software may be on a path to profitability. Pre-profit companies are often risky, but they can also offer great rewards. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Elmo Software has 2 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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