Is Praemium (ASX:PPS) Using Too Much Debt?

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 Praemium Limited (ASX:PPS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Praemium

What Is Praemium's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Praemium had debt of AU$15.1m, up from none in one year. However, it does have AU$28.9m in cash offsetting this, leading to net cash of AU$13.8m.

A Look At Praemium's Liabilities

The latest balance sheet data shows that Praemium had liabilities of AU$21.4m due within a year, and liabilities of AU$15.4m falling due after that. On the other hand, it had cash of AU$28.9m and AU$7.88m worth of receivables due within a year. So these liquid assets roughly match the total liabilities.

Having regard to Praemium's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the AU$341.0m company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Praemium also has more cash than debt, so we're pretty confident it can manage its debt safely.

It is just as well that Praemium's load is not too heavy, because its EBIT was down 34% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Praemium'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Praemium may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Praemium's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Praemium has AU$13.8m in net cash. So we don't have any problem with Praemium's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Praemium , and understanding them should be part of your investment process.

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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