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 Evolve Education Group Limited (NZSE:EVO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Evolve Education Group's Net Debt?
The image below, which you can click on for greater detail, shows that Evolve Education Group had debt of NZ$17.6m at the end of September 2020, a reduction from NZ$25.4m over a year. However, its balance sheet shows it holds NZ$39.3m in cash, so it actually has NZ$21.7m net cash.
How Healthy Is Evolve Education Group's Balance Sheet?
We can see from the most recent balance sheet that Evolve Education Group had liabilities of NZ$45.7m falling due within a year, and liabilities of NZ$198.0m due beyond that. Offsetting this, it had NZ$39.3m in cash and NZ$50.7k in receivables that were due within 12 months. So it has liabilities totalling NZ$204.4m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of NZ$186.0m, we think shareholders really should watch Evolve Education Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that Evolve Education Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Pleasingly, Evolve Education Group is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 159% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Evolve Education Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Evolve Education Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Evolve Education Group actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Evolve Education Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NZ$21.7m. The cherry on top was that in converted 124% of that EBIT to free cash flow, bringing in NZ$36m. So we are not troubled with Evolve Education Group's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 1 warning sign for Evolve Education Group you should know about.
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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