Is Naked Wines (LON:WINE) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Naked Wines plc (LON:WINE) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Naked Wines

How Much Debt Does Naked Wines Carry?

You can click the graphic below for the historical numbers, but it shows that as of October 2023 Naked Wines had UK£31.0m of debt, an increase on UK£18.8m, over one year. However, its balance sheet shows it holds UK£33.8m in cash, so it actually has UK£2.81m net cash.

A Look At Naked Wines' Liabilities

Zooming in on the latest balance sheet data, we can see that Naked Wines had liabilities of UK£133.3m due within 12 months and liabilities of UK£33.7m due beyond that. Offsetting these obligations, it had cash of UK£33.8m as well as receivables valued at UK£5.39m due within 12 months. So it has liabilities totalling UK£127.8m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the UK£42.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Naked Wines would likely require a major re-capitalisation if it had to pay its creditors today. Naked Wines boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

We also note that Naked Wines improved its EBIT from a last year's loss to a positive UK£7.2m. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Naked Wines'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Naked Wines 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 last year, Naked Wines saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

Although Naked Wines'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£2.81m. However, we do find both Naked Wines's level of total liabilities and its conversion of EBIT to free cash flow troubling. So despite the cash, we do think it carries some risks. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Naked Wines , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.