Here's Why Berkeley Group Holdings (LON:BKG) Can Manage Its Debt Responsibly

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. Importantly, The Berkeley Group Holdings plc (LON:BKG) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Berkeley Group Holdings

What Is Berkeley Group Holdings's Net Debt?

As you can see below, Berkeley Group Holdings had UK£300.0m of debt, at October 2019, which is about the same the year before. You can click the chart for greater detail. But it also has UK£1.36b in cash to offset that, meaning it has UK£1.06b net cash.

A Look At Berkeley Group Holdings's Liabilities

Zooming in on the latest balance sheet data, we can see that Berkeley Group Holdings had liabilities of UK£1.64b due within 12 months and liabilities of UK£418.1m due beyond that. Offsetting this, it had UK£1.36b in cash and UK£98.6m in receivables that were due within 12 months. So its liabilities total UK£598.4m more than the combination of its cash and short-term receivables.

Given Berkeley Group Holdings has a market capitalization of UK£6.68b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Berkeley Group Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

But the bad news is that Berkeley Group Holdings has seen its EBIT plunge 12% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Berkeley Group Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Berkeley Group 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. During the last three years, Berkeley Group Holdings produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Berkeley Group Holdings has UK£1.06b in net cash. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in UK£257m. So we are not troubled with Berkeley Group Holdings's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Berkeley Group Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.