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. Importantly, Neosperience S.p.A. (BIT:NSP) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Neosperience's Debt?
As you can see below, at the end of December 2018, Neosperience had €3.26m of debt, up from €2.74m a year ago. Click the image for more detail. On the flip side, it has €100.7k in cash leading to net debt of about €3.16m.
How Strong Is Neosperience's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Neosperience had liabilities of €8.22m due within 12 months and liabilities of €3.69m due beyond that. Offsetting these obligations, it had cash of €100.7k as well as receivables valued at €9.24m due within 12 months. So its liabilities total €2.56m more than the combination of its cash and short-term receivables.
Given Neosperience has a market capitalization of €63.7m, 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.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Neosperience has net debt of just 0.95 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 7.4 times the interest expense over the last year. And we also note warmly that Neosperience grew its EBIT by 12% last year, making its debt load easier to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Neosperience's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Neosperience saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Based on what we've seen Neosperience is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we thought its EBIT growth rate was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Neosperience's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Neosperience's earnings per share history for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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