Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Etion Limited (JSE:ETO) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Etion
What Is Etion's Debt?
As you can see below, Etion had R60.2m of debt at September 2020, down from R72.6m a year prior. However, it does have R60.4m in cash offsetting this, leading to net cash of R172.0k.
How Healthy Is Etion's Balance Sheet?
We can see from the most recent balance sheet that Etion had liabilities of R110.3m falling due within a year, and liabilities of R84.7m due beyond that. Offsetting this, it had R60.4m in cash and R130.5m in receivables that were due within 12 months. So it has liabilities totalling R4.09m more than its cash and near-term receivables, combined.
Of course, Etion has a market capitalization of R180.6m, 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. While it does have liabilities worth noting, Etion also has more cash than debt, so we're pretty confident it can manage its debt safely. When analysing debt levels, the balance sheet is the obvious place to start. But it is Etion'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.
Over 12 months, Etion made a loss at the EBIT level, and saw its revenue drop to R512m, which is a fall of 19%. That's not what we would hope to see.
So How Risky Is Etion?
Statistically speaking companies that lose money are riskier than those that make money. And the fact is that over the last twelve months Etion lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of R3.6m and booked a R37m accounting loss. Given it only has net cash of R172.0k, the company may need to raise more capital if it doesn't reach break-even soon. Overall, we'd say the stock is a bit risky, and we're usually very cautious until we see positive free cash flow. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Etion (1 is significant) you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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About JSE:ETO
Etion
Etion Limited provides original design manufacturing, safety and productivity, digital network, and cyber security solutions in South Africa.
Excellent balance sheet and slightly overvalued.
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