We Think Pro-Dex (NASDAQ:PDEX) Is Taking Some Risk With Its 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 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 Pro-Dex, Inc. (NASDAQ:PDEX) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pro-Dex

What Is Pro-Dex's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Pro-Dex had US$12.5m of debt, an increase on US$3.77m, over one year. However, because it has a cash reserve of US$6.68m, its net debt is less, at about US$5.78m.

How Strong Is Pro-Dex's Balance Sheet?

We can see from the most recent balance sheet that Pro-Dex had liabilities of US$6.21m falling due within a year, and liabilities of US$14.3m due beyond that. Offsetting these obligations, it had cash of US$6.68m as well as receivables valued at US$10.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.71m.

Of course, Pro-Dex has a market capitalization of US$77.4m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Pro-Dex's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 13.4 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Pro-Dex's saving grace is its low debt levels, because its EBIT has tanked 40% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Pro-Dex 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Pro-Dex actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Neither Pro-Dex's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We should also note that Medical Equipment industry companies like Pro-Dex commonly do use debt without problems. We think that Pro-Dex's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Be aware that Pro-Dex is showing 5 warning signs in our investment analysis , and 2 of those make us uncomfortable...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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