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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. As with many other companies. Precia SA (EPA:PREC) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Precia
What Is Precia's Debt?
As you can see below, Precia had €15.3m of debt at December 2018, down from €25.0m a year prior. But it also has €26.0m in cash to offset that, meaning it has €10.7m net cash.
How Healthy Is Precia's Balance Sheet?
The latest balance sheet data shows that Precia had liabilities of €43.9m due within a year, and liabilities of €15.8m falling due after that. Offsetting these obligations, it had cash of €26.0m as well as receivables valued at €34.9m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Precia's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the €97.3m company is struggling for cash, we still think it's worth monitoring its balance sheet. Precia boasts net cash, so it's fair to say it does not have a heavy debt load!
While Precia doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. There's no doubt that we learn most about debt from the balance sheet. But it is Precia's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Precia 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, Precia recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Precia has net cash of €11m, as well as more liquid assets than liabilities. So we don't have any problem with Precia's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Precia's earnings per share history for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.