Here's Why Psychemedics (NASDAQ:PMD) Can Afford Some Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that Psychemedics Corporation (NASDAQ:PMD) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Psychemedics

What Is Psychemedics's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Psychemedics had US$4.30m of debt, an increase on US$1.32m, over one year. However, because it has a cash reserve of US$1.81m, its net debt is less, at about US$2.49m.

How Strong Is Psychemedics' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Psychemedics had liabilities of US$3.34m due within 12 months and liabilities of US$7.70m due beyond that. Offsetting this, it had US$1.81m in cash and US$5.72m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.51m.

Of course, Psychemedics has a market capitalization of US$38.9m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. There's no doubt that we learn most about debt from the balance sheet. But it is Psychemedics's earnings that will influence how the balance sheet holds up in the future. 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.

Over 12 months, Psychemedics made a loss at the EBIT level, and saw its revenue drop to US$25m, which is a fall of 36%. That makes us nervous, to say the least.

Caveat Emptor

Not only did Psychemedics's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping US$4.8m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled US$6.0m in negative free cash flow over the last twelve months. So in short it's a really risky stock. 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. For instance, we've identified 3 warning signs for Psychemedics (1 is concerning) you should be aware of.

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.

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