Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, The Character Group plc (LON:CCT) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Character Group's Debt?
As you can see below, at the end of August 2019, Character Group had UK£22.5m of debt, up from UK£19.1m a year ago. Click the image for more detail. However, its balance sheet shows it holds UK£29.0m in cash, so it actually has UK£6.50m net cash.
How Healthy Is Character Group's Balance Sheet?
We can see from the most recent balance sheet that Character Group had liabilities of UK£51.7m falling due within a year, and liabilities of UK£1.31m due beyond that. Offsetting these obligations, it had cash of UK£29.0m as well as receivables valued at UK£35.0m due within 12 months. So it can boast UK£11.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Character Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Character Group boasts net cash, so it's fair to say it does not have a heavy debt load!
Character Group's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of 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 Character Group'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Character Group may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Character Group produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While we empathize with investors who find debt concerning, you should keep in mind that Character Group has net cash of UK£6.50m, as well as more liquid assets than liabilities. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in UK£5.8m. So is Character Group's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Character Group which any shareholder or potential investor should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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