Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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, Watkin Jones Plc (LON:WJG) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Watkin Jones
How Much Debt Does Watkin Jones Carry?
As you can see below, at the end of September 2019, Watkin Jones had UK£36.8m of debt, up from UK£24.5m a year ago. Click the image for more detail. However, its balance sheet shows it holds UK£115.7m in cash, so it actually has UK£78.9m net cash.
How Strong Is Watkin Jones's Balance Sheet?
According to the last reported balance sheet, Watkin Jones had liabilities of UK£95.8m due within 12 months, and liabilities of UK£41.1m due beyond 12 months. Offsetting these obligations, it had cash of UK£115.7m as well as receivables valued at UK£40.0m due within 12 months. So it can boast UK£18.7m more liquid assets than total liabilities.
This surplus suggests that Watkin Jones has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Watkin Jones boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that Watkin Jones has increased its EBIT by 5.4% over twelve months, which should ease any concerns about debt repayment. 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 Watkin Jones 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. Watkin Jones 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. During the last three years, Watkin Jones produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Watkin Jones has net cash of UK£78.9m, as well as more liquid assets than liabilities. So is Watkin Jones's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Watkin Jones (including 1 which is is a bit unpleasant) .
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.
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.
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