Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Vital Limited (NZSE:VTL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Vital Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Vital had NZ$14.5m of debt, an increase on NZ$12.8m, over one year. However, it also had NZ$1.86m in cash, and so its net debt is NZ$12.6m.
A Look At Vital’s Liabilities
Zooming in on the latest balance sheet data, we can see that Vital had liabilities of NZ$16.3m due within 12 months and liabilities of NZ$37.0m due beyond that. Offsetting this, it had NZ$1.86m in cash and NZ$4.15m in receivables that were due within 12 months. So its liabilities total NZ$47.2m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company’s market capitalization of NZ$33.9m, we think shareholders really should watch Vital’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Vital has a very low debt to EBITDA ratio of 1.5 so it is strange to see weak interest coverage, with last year’s EBIT being only 1.5 times the interest expense. So one way or the other, it’s clear the debt levels are not trivial. Shareholders should be aware that Vital’s EBIT was down 47% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Vital 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Vital’s free cash flow amounted to 27% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
To be frank both Vital’s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Vital has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 3 warning signs for Vital that you should be aware of.
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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This article by Simply Wall St is general in nature. 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.
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