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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. As with many other companies. The Character Group plc (LON:CCT) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Character Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of February 2019 Character Group had UK£3.72m of debt, an increase on none, over one year. However, its balance sheet shows it holds UK£23.5m in cash, so it actually has UK£19.8m net cash.
A Look At Character Group’s Liabilities
We can see from the most recent balance sheet that Character Group had liabilities of UK£21.7m falling due within a year, and liabilities of UK£1.66m due beyond that. Offsetting this, it had UK£23.5m in cash and UK£12.9m in receivables that were due within 12 months. So it can boast UK£13.0m more liquid assets than total liabilities.
This surplus suggests that Character Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Character Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
And we also note warmly that Character Group grew its EBIT by 18% last year, making its debt load easier to handle. 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, a company can only pay off debt with cold hard cash, not accounting profits. While Character Group 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. During the last three years, Character Group generated free cash flow amounting to a very robust 82% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
While it is always sensible to investigate a company’s debt, in this case Character Group has UK£20m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of UK£18m, being 82% of its EBIT. So we don’t think Character Group’s use of debt is risky. Given Character Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.