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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Savills plc (LON:SVS) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Savills's Debt?
As you can see below, Savills had UK£226.2m of debt at June 2020, down from UK£300.1m a year prior. However, it does have UK£235.6m in cash offsetting this, leading to net cash of UK£9.40m.
How Strong Is Savills's Balance Sheet?
The latest balance sheet data shows that Savills had liabilities of UK£610.1m due within a year, and liabilities of UK£432.2m falling due after that. Offsetting this, it had UK£235.6m in cash and UK£438.8m in receivables that were due within 12 months. So it has liabilities totalling UK£367.9m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Savills has a market capitalization of UK£1.35b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Savills boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Savills saw its EBIT drop by 5.6% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Savills 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Savills 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, Savills generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Savills'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£9.40m. The cherry on top was that in converted 81% of that EBIT to free cash flow, bringing in UK£217m. So we don't have any problem with Savills's use of debt. 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. To that end, you should be aware of the 1 warning sign we've spotted with Savills .
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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