Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, AIREA plc (LON:AIEA) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does AIREA Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 AIREA had UK£3.90m of debt, an increase on UK£1.55m, over one year. However, it does have UK£6.45m in cash offsetting this, leading to net cash of UK£2.55m.
A Look At AIREA's Liabilities
According to the last reported balance sheet, AIREA had liabilities of UK£3.60m due within 12 months, and liabilities of UK£9.03m due beyond 12 months. Offsetting this, it had UK£6.45m in cash and UK£1.92m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£4.26m.
This deficit isn't so bad because AIREA is worth UK£10.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, AIREA also has more cash than debt, so we're pretty confident it can manage its debt safely.
It is just as well that AIREA's load is not too heavy, because its EBIT was down 58% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since AIREA will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While AIREA 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. Happily for any shareholders, AIREA actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although AIREA's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£2.55m. The cherry on top was that in converted 111% of that EBIT to free cash flow, bringing in UK£3.4m. So we don't have any problem with AIREA's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that AIREA is showing 3 warning signs in our investment analysis , you should know about...
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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