Faze Three (NSE:FAZE3Q) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Faze Three Limited (NSE:FAZE3Q) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Faze Three

What Is Faze Three's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Faze Three had ₹1.58b of debt, an increase on ₹1.51b, over one year. On the flip side, it has ₹540.1m in cash leading to net debt of about ₹1.04b.

How Healthy Is Faze Three's Balance Sheet?

We can see from the most recent balance sheet that Faze Three had liabilities of ₹2.11b falling due within a year, and liabilities of ₹183.5m due beyond that. On the other hand, it had cash of ₹540.1m and ₹665.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹1.09b.

Given Faze Three has a market capitalization of ₹10.1b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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).

Faze Three has net debt of just 1.3 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.9 times the interest expense over the last year. But the bad news is that Faze Three has seen its EBIT plunge 20% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But it is Faze Three's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Faze Three actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Both Faze Three's EBIT growth rate and its conversion of EBIT to free cash flow were discouraging. At least its interest cover gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Faze Three is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 1 warning sign for Faze Three that you should be aware of.

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.