The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Italtile Limited (JSE:ITE) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Italtile's Debt?
The image below, which you can click on for greater detail, shows that at December 2021 Italtile had debt of R539.0m, up from R508.0m in one year. But it also has R548.0m in cash to offset that, meaning it has R9.00m net cash.
How Strong Is Italtile's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Italtile had liabilities of R727.0m due within 12 months and liabilities of R1.05b due beyond that. Offsetting this, it had R548.0m in cash and R924.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R302.0m.
This state of affairs indicates that Italtile's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the R21.5b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Italtile boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that Italtile has boosted its EBIT by 39%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Italtile'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Italtile has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Italtile recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
We could understand if investors are concerned about Italtile's liabilities, but we can be reassured by the fact it has has net cash of R9.00m. And we liked the look of last year's 39% year-on-year EBIT growth. So is Italtile's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Italtile has 1 warning sign we think 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. 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.