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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Orcoda Limited (ASX:ODA) does carry debt. But the more important question is: how much risk is that debt creating?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Orcoda's Debt?
As you can see below, at the end of December 2020, Orcoda had AU$2.37m of debt, up from none a year ago. Click the image for more detail. However, it also had AU$708.9k in cash, and so its net debt is AU$1.66m.
How Strong Is Orcoda's Balance Sheet?
According to the last reported balance sheet, Orcoda had liabilities of AU$2.39m due within 12 months, and liabilities of AU$3.45m due beyond 12 months. Offsetting these obligations, it had cash of AU$708.9k as well as receivables valued at AU$2.12m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$3.00m.
Given Orcoda has a market capitalization of AU$25.2m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Orcoda will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
In the last year Orcoda wasn't profitable at an EBIT level, but managed to grow its revenue by 3.9%, to AU$3.4m. We usually like to see faster growth from unprofitable companies, but each to their own.
Over the last twelve months Orcoda produced an earnings before interest and tax (EBIT) loss. Indeed, it lost AU$1.3m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through AU$1.6m of cash over the last year. So suffice it to say we consider the stock very risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 6 warning signs for Orcoda (of which 2 make us uncomfortable!) you should know about.
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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