Is Pure Cycle (NASDAQ:PCYO) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Pure Cycle Corporation (NASDAQ:PCYO) does use debt in its business. But is this debt a concern to shareholders?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Pure Cycle

What Is Pure Cycle's Net Debt?

The image below, which you can click on for greater detail, shows that at February 2023 Pure Cycle had debt of US$3.96m, up from US$1.00m in one year. However, it does have US$22.5m in cash offsetting this, leading to net cash of US$18.5m.

A Look At Pure Cycle's Liabilities

We can see from the most recent balance sheet that Pure Cycle had liabilities of US$6.47m falling due within a year, and liabilities of US$5.14m due beyond that. Offsetting this, it had US$22.5m in cash and US$3.73m in receivables that were due within 12 months. So it can boast US$14.6m more liquid assets than total liabilities.

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

The good news is that Pure Cycle has increased its EBIT by 2.6% over twelve months, which should ease any concerns about debt repayment. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Pure Cycle 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Pure Cycle 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. In the last three years, Pure Cycle created free cash flow amounting to 7.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Pure Cycle has US$18.5m in net cash and a decent-looking balance sheet. And it also grew its EBIT by 2.6% over the last year. So we don't have any problem with Pure Cycle's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Pure Cycle's earnings per share history for free.

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.