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.' 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. As with many other companies The Berkeley Group Holdings plc (LON:BKG) makes use of debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. 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.
What Is Berkeley Group Holdings's Net Debt?
As you can see below, Berkeley Group Holdings had UK£300.0m of debt, at October 2020, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has UK£1.25b in cash, leading to a UK£954.3m net cash position.
How Strong Is Berkeley Group Holdings' Balance Sheet?
According to the last reported balance sheet, Berkeley Group Holdings had liabilities of UK£1.80b due within 12 months, and liabilities of UK£695.1m due beyond 12 months. Offsetting this, it had UK£1.25b in cash and UK£81.0m in receivables that were due within 12 months. So it has liabilities totalling UK£1.16b more than its cash and near-term receivables, combined.
Berkeley Group Holdings has a market capitalization of UK£5.36b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Berkeley Group Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Berkeley Group Holdings if management cannot prevent a repeat of the 29% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Berkeley Group Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Berkeley Group Holdings 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. Over the most recent three years, Berkeley Group Holdings recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Berkeley Group Holdings'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£954.3m. So we don't have any problem with Berkeley Group Holdings's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Berkeley Group Holdings has 2 warning signs we think you 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.
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