Macfarlane Group (LON:MACF) Seems To Use Debt Quite Sensibly

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.' 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 Macfarlane Group PLC (LON:MACF) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Macfarlane Group

What Is Macfarlane Group's Net Debt?

As you can see below, Macfarlane Group had UK£7.77m of debt at December 2020, down from UK£16.0m a year prior. On the flip side, it has UK£7.23m in cash leading to net debt of about UK£538.0k.

A Look At Macfarlane Group's Liabilities

We can see from the most recent balance sheet that Macfarlane Group had liabilities of UK£64.9m falling due within a year, and liabilities of UK£28.1m due beyond that. Offsetting this, it had UK£7.23m in cash and UK£51.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£34.3m.

While this might seem like a lot, it is not so bad since Macfarlane Group has a market capitalization of UK£164.1m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Carrying virtually no net debt, Macfarlane Group has a very light debt load indeed.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Macfarlane Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.021 and EBIT of 11.3 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. Fortunately, Macfarlane Group grew its EBIT by 6.5% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Macfarlane Group 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Macfarlane Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Macfarlane Group's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Zooming out, Macfarlane Group seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Macfarlane Group that you should be aware of.

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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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. 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.
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