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

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We note that Quality & Reliability A.B.E.E. (ATH:QUAL) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Quality & ReliabilityE.E

How Much Debt Does Quality & ReliabilityE.E Carry?

As you can see below, at the end of June 2024, Quality & ReliabilityE.E had €5.32m of debt, up from €4.71m a year ago. Click the image for more detail. However, because it has a cash reserve of €1.52m, its net debt is less, at about €3.79m.

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

Zooming in on the latest balance sheet data, we can see that Quality & ReliabilityE.E had liabilities of €11.3m due within 12 months and liabilities of €2.23m due beyond that. On the other hand, it had cash of €1.52m and €8.46m worth of receivables due within a year. So it has liabilities totalling €3.55m more than its cash and near-term receivables, combined.

Given Quality & ReliabilityE.E has a market capitalization of €33.0m, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Quality & ReliabilityE.E's debt to EBITDA ratio (3.3) suggests that it uses some debt, its interest cover is very weak, at 2.5, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. However, it should be some comfort for shareholders to recall that Quality & ReliabilityE.E actually grew its EBIT by a hefty 760%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, 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

Quality & ReliabilityE.E's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. We think that Quality & ReliabilityE.E's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 3 warning signs we've spotted with Quality & ReliabilityE.E (including 2 which are potentially serious) .

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.

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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.