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 Volex plc (LON:VLX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Volex
What Is Volex's Net Debt?
The image below, which you can click on for greater detail, shows that Volex had debt of US$2.20m at the end of October 2020, a reduction from US$9.96m over a year. However, it does have US$34.2m in cash offsetting this, leading to net cash of US$32.0m.
A Look At Volex's Liabilities
According to the last reported balance sheet, Volex had liabilities of US$107.3m due within 12 months, and liabilities of US$15.1m due beyond 12 months. Offsetting this, it had US$34.2m in cash and US$81.7m in receivables that were due within 12 months. So it has liabilities totalling US$6.47m more than its cash and near-term receivables, combined.
This state of affairs indicates that Volex'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 US$644.0m company is struggling for cash, we still think it's worth monitoring its balance sheet. Despite its noteworthy liabilities, Volex boasts net cash, so it's fair to say it does not have a heavy debt load!
But the other side of the story is that Volex saw its EBIT decline by 3.2% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Volex's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Volex 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 three years, Volex generated free cash flow amounting to a very robust 97% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Summing up
While it is always sensible to look at a company's total liabilities, it is very reassuring that Volex has US$32.0m in net cash. The cherry on top was that in converted 97% of that EBIT to free cash flow, bringing in US$43m. So we don't think Volex's use of debt is risky. 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. For instance, we've identified 1 warning sign for Volex that you should be aware of.
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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About AIM:VLX
Volex
Manufactures and sells power and data cables in North America, Europe, and Asia.
Undervalued with proven track record.
