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.' 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. We note that Integrated Research Limited (ASX:IRI) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Integrated Research's Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Integrated Research had debt of AU$6.66m, up from AU$5.00m in one year. However, its balance sheet shows it holds AU$12.1m in cash, so it actually has AU$5.49m net cash.
A Look At Integrated Research's Liabilities
Zooming in on the latest balance sheet data, we can see that Integrated Research had liabilities of AU$31.7m due within 12 months and liabilities of AU$20.0m due beyond that. Offsetting this, it had AU$12.1m in cash and AU$53.4m in receivables that were due within 12 months. So it can boast AU$13.8m more liquid assets than total liabilities.
This surplus suggests that Integrated Research has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Integrated Research has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Integrated Research's load is not too heavy, because its EBIT was down 70% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Integrated Research'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Integrated Research 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. Looking at the most recent three years, Integrated Research recorded free cash flow of 38% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While it is always sensible to investigate a company's debt, in this case Integrated Research has AU$5.49m in net cash and a decent-looking balance sheet. So we are not troubled with Integrated Research's debt use. 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. Case in point: We've spotted 1 warning sign for Integrated Research you should be aware of.
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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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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