Rakon (NZSE:RAK) Could Easily Take On More Debt

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.' 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 Rakon Limited (NZSE:RAK) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Rakon

What Is Rakon's Net Debt?

As you can see below, at the end of March 2022, Rakon had NZ$16.0m of debt, up from NZ$10.0m a year ago. Click the image for more detail. But it also has NZ$39.4m in cash to offset that, meaning it has NZ$23.4m net cash.

A Look At Rakon's Liabilities

We can see from the most recent balance sheet that Rakon had liabilities of NZ$43.3m falling due within a year, and liabilities of NZ$21.4m due beyond that. On the other hand, it had cash of NZ$39.4m and NZ$43.2m worth of receivables due within a year. So it actually has NZ$18.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Rakon could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Rakon has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Rakon grew its EBIT by 316% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Rakon's ability to maintain a healthy balance sheet going forward. 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. Rakon 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, Rakon produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Rakon has net cash of NZ$23.4m, as well as more liquid assets than liabilities. And we liked the look of last year's 316% year-on-year EBIT growth. So we don't think Rakon's use of debt is risky. Another factor that would give us confidence in Rakon would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.