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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Ultra Electronics Holdings plc (LON:ULE) 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. If things get really bad, the lenders can take control of the business. 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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Ultra Electronics Holdings's Net Debt?
As you can see below, Ultra Electronics Holdings had UK£141.7m of debt at July 2021, down from UK£156.8m a year prior. On the flip side, it has UK£120.6m in cash leading to net debt of about UK£21.1m.
How Strong Is Ultra Electronics Holdings' Balance Sheet?
According to the last reported balance sheet, Ultra Electronics Holdings had liabilities of UK£263.9m due within 12 months, and liabilities of UK£240.2m due beyond 12 months. Offsetting this, it had UK£120.6m in cash and UK£181.7m in receivables that were due within 12 months. So its liabilities total UK£201.8m more than the combination of its cash and short-term receivables.
Given Ultra Electronics Holdings has a market capitalization of UK£2.24b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Carrying virtually no net debt, Ultra Electronics Holdings has a very light debt load indeed.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Ultra Electronics Holdings has a low net debt to EBITDA ratio of only 0.15. And its EBIT covers its interest expense a whopping 15.9 times over. So we're pretty relaxed about its super-conservative use of debt. Also good is that Ultra Electronics Holdings grew its EBIT at 17% 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Ultra Electronics Holdings recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
The good news is that Ultra Electronics Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Overall, we don't think Ultra Electronics Holdings is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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. To that end, you should be aware of the 1 warning sign we've spotted with Ultra Electronics Holdings .
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.
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