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.' 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 can see that SKY Network Television Limited (NZSE:SKT) does use debt in its business. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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.
What Is SKY Network Television's Debt?
The image below, which you can click on for greater detail, shows that SKY Network Television had debt of NZ$101.5m at the end of December 2020, a reduction from NZ$217.0m over a year. However, it does have NZ$123.3m in cash offsetting this, leading to net cash of NZ$21.7m.
How Healthy Is SKY Network Television's Balance Sheet?
The latest balance sheet data shows that SKY Network Television had liabilities of NZ$325.3m due within a year, and liabilities of NZ$57.9m falling due after that. Offsetting these obligations, it had cash of NZ$123.3m as well as receivables valued at NZ$54.1m due within 12 months. So its liabilities total NZ$205.8m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of NZ$314.4m, so it does suggest shareholders should keep an eye on SKY Network Television's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, SKY Network Television also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also good is that SKY Network Television grew its EBIT at 16% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if SKY Network Television can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. SKY Network Television may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, SKY Network Television generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although SKY Network Television'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. And it impressed us with free cash flow of NZ$123m, being 87% of its EBIT. So we don't have any problem with SKY Network Television's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with SKY Network Television .
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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