Quality & ReliabilityE.E (ATH:QUAL) Takes On Some Risk With Its Use Of Debt

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.' 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, Quality & Reliability A.B.E.E (ATH:QUAL) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Quality & ReliabilityE.E

What Is Quality & ReliabilityE.E's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Quality & ReliabilityE.E had debt of €3.70m, up from €3.13m in one year. However, it also had €152.6k in cash, and so its net debt is €3.55m.

How Healthy Is Quality & ReliabilityE.E's Balance Sheet?

The latest balance sheet data shows that Quality & ReliabilityE.E had liabilities of €4.36m due within a year, and liabilities of €2.00m falling due after that. Offsetting these obligations, it had cash of €152.6k as well as receivables valued at €5.43m due within 12 months. So it has liabilities totalling €783.5k more than its cash and near-term receivables, combined.

Given Quality & ReliabilityE.E has a market capitalization of €11.6m, 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.

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.

Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 15.3 hit our confidence in Quality & ReliabilityE.E like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Quality & ReliabilityE.E achieved a positive EBIT of €398k in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But it is Quality & ReliabilityE.E's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Quality & ReliabilityE.E burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Quality & ReliabilityE.E's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Quality & ReliabilityE.E stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Quality & ReliabilityE.E (2 don't sit too well with us!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.