Stock Analysis

Health Check: How Prudently Does Velocity Composites (LON:VEL) Use Debt?

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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Velocity Composites plc (LON:VEL) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

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What Is Velocity Composites's Debt?

You can click the graphic below for the historical numbers, but it shows that as of October 2020 Velocity Composites had UK£2.00m of debt, an increase on UK£4.0k, over one year. However, it does have UK£3.27m in cash offsetting this, leading to net cash of UK£1.27m.

AIM:VEL Debt to Equity History January 28th 2021

How Healthy Is Velocity Composites' Balance Sheet?

We can see from the most recent balance sheet that Velocity Composites had liabilities of UK£2.42m falling due within a year, and liabilities of UK£2.56m due beyond that. On the other hand, it had cash of UK£3.27m and UK£2.46m worth of receivables due within a year. So it actually has UK£757.0k more liquid assets than total liabilities.

This surplus suggests that Velocity Composites has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Velocity Composites boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Velocity Composites 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 Velocity Composites had a loss before interest and tax, and actually shrunk its revenue by 44%, to UK£14m. To be frank that doesn't bode well.

So How Risky Is Velocity Composites?

Statistically speaking companies that lose money are riskier than those that make money. And the fact is that over the last twelve months Velocity Composites lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of UK£1.9m and booked a UK£3.1m accounting loss. While this does make the company a bit risky, it's important to remember it has net cash of UK£1.27m. That kitty means the company can keep spending for growth for at least two years, at current rates. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Velocity Composites (2 can't be ignored) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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