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. We note that RWS Holdings plc (LON:RWS) does have debt on its balance sheet. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is RWS Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that RWS Holdings had UK£47.2m of debt in September 2021, down from UK£66.5m, one year before. But it also has UK£92.5m in cash to offset that, meaning it has UK£45.3m net cash.
How Healthy Is RWS Holdings' Balance Sheet?
We can see from the most recent balance sheet that RWS Holdings had liabilities of UK£190.9m falling due within a year, and liabilities of UK£145.4m due beyond that. Offsetting these obligations, it had cash of UK£92.5m as well as receivables valued at UK£195.3m due within 12 months. So its liabilities total UK£48.5m more than the combination of its cash and short-term receivables.
Of course, RWS Holdings has a market capitalization of UK£2.22b, 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. While it does have liabilities worth noting, RWS Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, RWS Holdings grew its EBIT by 46% 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 it is future earnings, more than anything, that will determine RWS Holdings'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, a company can only pay off debt with cold hard cash, not accounting profits. While RWS Holdings 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, RWS 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.
We could understand if investors are concerned about RWS Holdings's liabilities, but we can be reassured by the fact it has has net cash of UK£45.3m. And it impressed us with free cash flow of UK£62m, being 97% of its EBIT. So we don't think RWS Holdings's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - RWS Holdings has 3 warning signs we think you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.