Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Quarterhill Inc. (TSE:QTRH) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Quarterhill's Net Debt?
As you can see below, Quarterhill had US$4.75m of debt at June 2019, down from US$6.50m a year prior. However, it does have US$85.8m in cash offsetting this, leading to net cash of US$81.1m.
A Look At Quarterhill's Liabilities
We can see from the most recent balance sheet that Quarterhill had liabilities of US$43.3m falling due within a year, and liabilities of US$7.32m due beyond that. Offsetting these obligations, it had cash of US$85.8m as well as receivables valued at US$16.5m due within 12 months. So it actually has US$51.6m more liquid assets than total liabilities.
This surplus liquidity suggests that Quarterhill's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, it seems its balance sheet is as strong as a black-belt karate master. Simply put, the fact that Quarterhill has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Quarterhill if management cannot prevent a repeat of the 97% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Quarterhill'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, a company can only pay off debt with cold hard cash, not accounting profits. Quarterhill may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Quarterhill actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company's debt, in this case Quarterhill has US$81m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 379% of that EBIT to free cash flow, bringing in US$21m. So we don't think Quarterhill's use of debt is risky. We'd be motivated to research the stock further if we found out that Quarterhill insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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