Is Velan (TSE:VLN) Using Too Much Debt?

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.' 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. We note that Velan Inc. (TSE:VLN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Velan

What Is Velan's Debt?

The image below, which you can click on for greater detail, shows that Velan had debt of US$56.6m at the end of November 2020, a reduction from US$59.5m over a year. But it also has US$89.0m in cash to offset that, meaning it has US$32.4m net cash.

How Healthy Is Velan's Balance Sheet?

We can see from the most recent balance sheet that Velan had liabilities of US$193.5m falling due within a year, and liabilities of US$63.2m due beyond that. On the other hand, it had cash of US$89.0m and US$129.7m worth of receivables due within a year. So its liabilities total US$38.1m more than the combination of its cash and short-term receivables.

Velan has a market capitalization of US$135.4m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Velan boasts net cash, so it's fair to say it does not have a heavy debt load!

The bad news is that Velan saw its EBIT decline by 14% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Velan's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Velan 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 two years, Velan burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

While Velan does have more liabilities than liquid assets, it also has net cash of US$32.4m. Despite the cash, we do find Velan's conversion of EBIT to free cash flow concerning, so we're not particularly comfortable with the stock. The balance sheet is clearly the area to focus on when you are analysing debt. 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 2 warning signs for Velan (of which 1 is concerning!) 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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This article by Simply Wall St is general in nature. 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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