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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Italtile Limited (JSE:ITE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Italtile's Debt?
As you can see below, Italtile had R507.0m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds R1.08b in cash, so it actually has R574.0m net cash.
How Healthy Is Italtile's Balance Sheet?
According to the last reported balance sheet, Italtile had liabilities of R1.37b due within 12 months, and liabilities of R526.0m due beyond 12 months. On the other hand, it had cash of R1.08b and R879.0m worth of receivables due within a year. So it can boast R66.0m more liquid assets than total liabilities.
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 while it's hard to imagine that the R20.6b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Italtile has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that Italtile has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is Italtile's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Italtile has R574.0m in net cash and a decent-looking balance sheet. And we liked the look of last year's 32% year-on-year EBIT growth. So we don't think Italtile's use of debt is risky. We'd be very excited to see if Italtile insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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