Is Virco Mfg (NASDAQ:VIRC) A Risky Investment?

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Virco Mfg. Corporation (NASDAQ:VIRC) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Virco Mfg

What Is Virco Mfg's Debt?

The image below, which you can click on for greater detail, shows that at October 2022 Virco Mfg had debt of US$16.9m, up from US$13.1m in one year. However, it does have US$2.18m in cash offsetting this, leading to net debt of about US$14.7m.

How Strong Is Virco Mfg's Balance Sheet?

The latest balance sheet data shows that Virco Mfg had liabilities of US$43.2m due within a year, and liabilities of US$36.5m falling due after that. On the other hand, it had cash of US$2.18m and US$28.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$49.3m.

This is a mountain of leverage relative to its market capitalization of US$62.7m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

While Virco Mfg's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that Virco Mfg improved its EBIT from a last year's loss to a positive US$9.6m. 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 Virco Mfg 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Virco Mfg saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say Virco Mfg's conversion of EBIT to free cash flow was disappointing. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Virco Mfg has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Virco Mfg is showing 1 warning sign in our investment analysis , 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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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.