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.' 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. As with many other companies Elecosoft plc (LON:ELCO) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Elecosoft Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Elecosoft had UK£7.85m of debt, an increase on UK£3.71m, over one year. On the flip side, it has UK£6.04m in cash leading to net debt of about UK£1.81m.
How Healthy Is Elecosoft's Balance Sheet?
We can see from the most recent balance sheet that Elecosoft had liabilities of UK£11.5m falling due within a year, and liabilities of UK£7.99m due beyond that. Offsetting these obligations, it had cash of UK£6.04m as well as receivables valued at UK£4.01m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£9.50m.
Of course, Elecosoft has a market capitalization of UK£60.5m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Elecosoft has a low net debt to EBITDA ratio of only 0.39. And its EBIT covers its interest expense a whopping 17.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Elecosoft has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Elecosoft's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Elecosoft produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Elecosoft's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Considering this range of factors, it seems to us that Elecosoft is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. Over time, share prices tend to follow earnings per share, so if you're interested in Elecosoft, you may well want to click here to check an interactive graph of its earnings per share history.
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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