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. 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 can see that Augean plc (LON:AUG) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Augean Carry?
As you can see below, Augean had UK£2.94m of debt at June 2019, down from UK£7.90m a year prior. However, it does have UK£25.8m in cash offsetting this, leading to net cash of UK£22.8m.
How Strong Is Augean’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Augean had liabilities of UK£31.7m due within 12 months and liabilities of UK£12.0m due beyond that. On the other hand, it had cash of UK£25.8m and UK£20.0m worth of receivables due within a year. So it can boast UK£2.08m more liquid assets than total liabilities.
Having regard to Augean’s size, it seems that its liquid assets are well balanced with its total liabilities. So it’s very unlikely that the UK£114.0m company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Augean has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, Augean grew its EBIT by 83% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Augean’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Augean 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. Over the last three years, Augean recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Augean has net cash of UK£22.8m, as well as more liquid assets than liabilities. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in UK£21m. So we don’t think Augean’s use of debt is risky. Over time, share prices tend to follow earnings per share, so if you’re interested in Augean, you may well want to click here to check an interactive graph of its earnings per share history.
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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