Is Observe Medical (OB:OBSRV) Using Debt In A Risky Way?

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 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. As with many other companies Observe Medical ASA (OB:OBSRV) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Observe Medical

How Much Debt Does Observe Medical Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2022 Observe Medical had kr57.6m of debt, an increase on kr35.5m, over one year. But it also has kr71.0m in cash to offset that, meaning it has kr13.4m net cash.

How Strong Is Observe Medical's Balance Sheet?

The latest balance sheet data shows that Observe Medical had liabilities of kr37.7m due within a year, and liabilities of kr57.8m falling due after that. Offsetting this, it had kr71.0m in cash and kr6.94m in receivables that were due within 12 months. So it has liabilities totalling kr17.6m more than its cash and near-term receivables, combined.

Given Observe Medical has a market capitalization of kr300.6m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Observe Medical also has more cash than debt, so we're pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Observe Medical will need earnings to service that debt. 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.

Over 12 months, Observe Medical reported revenue of kr29m, which is a gain of 374%, although it did not report any earnings before interest and tax. That's virtually the hole-in-one of revenue growth!

So How Risky Is Observe Medical?

By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that Observe Medical had an earnings before interest and tax (EBIT) loss, over the last year. Indeed, in that time it burnt through kr27m of cash and made a loss of kr31m. Given it only has net cash of kr13.4m, the company may need to raise more capital if it doesn't reach break-even soon. Importantly, Observe Medical's revenue growth is hot to trot. While unprofitable companies can be risky, they can also grow hard and fast in those pre-profit years. 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 4 warning signs for Observe Medical (2 are significant) 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.