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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Vertoz Advertising Limited (NSE:VERTOZ) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Vertoz Advertising's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 Vertoz Advertising had debt of ₹116.1m, up from ₹104.9m in one year. However, it does have ₹31.5m in cash offsetting this, leading to net debt of about ₹84.6m.
A Look At Vertoz Advertising's Liabilities
The latest balance sheet data shows that Vertoz Advertising had liabilities of ₹233.2m due within a year, and liabilities of ₹32.5m falling due after that. Offsetting these obligations, it had cash of ₹31.5m as well as receivables valued at ₹161.2m due within 12 months. So its liabilities total ₹72.9m more than the combination of its cash and short-term receivables.
Since publicly traded Vertoz Advertising shares are worth a total of ₹3.22b, it seems unlikely that this level of liabilities would be a major 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). 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).
Vertoz Advertising has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 3.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, Vertoz Advertising's EBIT was down 47% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Vertoz Advertising'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.
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. During the last three years, Vertoz Advertising burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Vertoz Advertising's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Vertoz Advertising has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Vertoz Advertising .
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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