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 can see that Eleco Plc (LON:ELCO) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Eleco Carry?
You can click the graphic below for the historical numbers, but it shows that Eleco had UK£4.51m of debt in December 2020, down from UK£6.14m, one year before. But it also has UK£10.7m in cash to offset that, meaning it has UK£6.15m net cash.
How Strong Is Eleco's Balance Sheet?
We can see from the most recent balance sheet that Eleco had liabilities of UK£12.9m falling due within a year, and liabilities of UK£6.18m due beyond that. On the other hand, it had cash of UK£10.7m and UK£3.56m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£4.84m.
Given Eleco has a market capitalization of UK£98.6m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Eleco boasts net cash, so it's fair to say it does not have a heavy debt load!
Fortunately, Eleco grew its EBIT by 9.4% 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 Eleco 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Eleco 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 three years, Eleco actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Eleco has UK£6.15m in net cash. And it impressed us with free cash flow of UK£5.4m, being 108% of its EBIT. So is Eleco's debt a risk? It doesn't seem so to us. We'd be very excited to see if Eleco insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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