Is Vertu Motors (LON:VTU) 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.' 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. We note that Vertu Motors plc (LON:VTU) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Vertu Motors

What Is Vertu Motors's Net Debt?

The image below, which you can click on for greater detail, shows that at August 2023 Vertu Motors had debt of UK£138.6m, up from UK£68.0m in one year. However, because it has a cash reserve of UK£47.9m, its net debt is less, at about UK£90.7m.

How Strong Is Vertu Motors' Balance Sheet?

We can see from the most recent balance sheet that Vertu Motors had liabilities of UK£791.0m falling due within a year, and liabilities of UK£230.3m due beyond that. Offsetting this, it had UK£47.9m in cash and UK£89.7m in receivables that were due within 12 months. So it has liabilities totalling UK£883.7m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the UK£222.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Vertu Motors would likely require a major re-capitalisation if it had to pay its creditors today.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Looking at its net debt to EBITDA of 0.91 and interest cover of 5.0 times, it seems to us that Vertu Motors is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Importantly, Vertu Motors grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Vertu Motors 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Vertu Motors's free cash flow amounted to 46% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Vertu Motors's level of total liabilities and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Taking the abovementioned factors together we do think Vertu Motors's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 4 warning signs with Vertu Motors , 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.