Vesuvius (LON:VSVS) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Vesuvius plc (LON:VSVS) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the GB Machinery industry.

What Is Vesuvius's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Vesuvius had debt of UK£457.0m, up from UK£310.7m in one year. However, because it has a cash reserve of UK£177.2m, its net debt is less, at about UK£279.8m.

How Strong Is Vesuvius' Balance Sheet?

We can see from the most recent balance sheet that Vesuvius had liabilities of UK£606.0m falling due within a year, and liabilities of UK£499.4m due beyond that. Offsetting this, it had UK£177.2m in cash and UK£549.4m in receivables that were due within 12 months. So its liabilities total UK£378.8m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Vesuvius has a market capitalization of UK£1.01b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Vesuvius has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 22.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Vesuvius grew its EBIT by 65% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Vesuvius can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Vesuvius's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Happily, Vesuvius's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! When we consider the range of factors above, it looks like Vesuvius is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Vesuvius is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.