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. 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 can see that Eurotech S.p.A. (BIT:ETH) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Eurotech's Net Debt?
As you can see below, at the end of June 2019, Eurotech had €15.3m of debt, up from €11.4m a year ago. Click the image for more detail. But on the other hand it also has €20.4m in cash, leading to a €5.15m net cash position.
A Look At Eurotech's Liabilities
We can see from the most recent balance sheet that Eurotech had liabilities of €33.3m falling due within a year, and liabilities of €15.2m due beyond that. Offsetting these obligations, it had cash of €20.4m as well as receivables valued at €19.3m due within 12 months. So its liabilities total €8.71m more than the combination of its cash and short-term receivables.
Given Eurotech has a market capitalization of €331.2m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Eurotech also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Eurotech grew its EBIT by 80% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Eurotech'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Eurotech 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 two years, Eurotech recorded free cash flow worth 73% 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.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Eurotech has €5.15m in net cash. And it impressed us with its EBIT growth of 80% over the last year. So we don't think Eurotech's use of debt is risky. We'd be very excited to see if Eurotech 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.
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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