David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Ultra Electronics Holdings plc (LON:ULE) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Ultra Electronics Holdings Carry?
As you can see below, Ultra Electronics Holdings had UK£162.5m of debt at December 2020, down from UK£224.1m a year prior. However, because it has a cash reserve of UK£114.4m, its net debt is less, at about UK£48.1m.
A Look At Ultra Electronics Holdings' Liabilities
We can see from the most recent balance sheet that Ultra Electronics Holdings had liabilities of UK£263.3m falling due within a year, and liabilities of UK£267.1m due beyond that. Offsetting these obligations, it had cash of UK£114.4m as well as receivables valued at UK£186.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£229.3m.
Of course, Ultra Electronics Holdings has a market capitalization of UK£1.47b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Ultra Electronics Holdings's net debt is only 0.36 times its EBITDA. And its EBIT easily covers its interest expense, being 15.8 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Ultra Electronics Holdings grew its EBIT at 10% over the last year, further increasing its ability to manage debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ultra Electronics Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Ultra Electronics Holdings recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Ultra Electronics Holdings's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Zooming out, Ultra Electronics Holdings seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We'd be very excited to see if Ultra Electronics Holdings insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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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