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. We note that Avingtrans plc (LON:AVG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Avingtrans Carry?
The image below, which you can click on for greater detail, shows that at May 2019 Avingtrans had debt of UK£8.76m, up from UK£11.2 in one year. But on the other hand it also has UK£8.91m in cash, leading to a UK£147.0k net cash position.
How Healthy Is Avingtrans's Balance Sheet?
The latest balance sheet data shows that Avingtrans had liabilities of UK£42.6m due within a year, and liabilities of UK£10.4m falling due after that. On the other hand, it had cash of UK£8.91m and UK£28.5m worth of receivables due within a year. So its liabilities total UK£15.6m more than the combination of its cash and short-term receivables.
Since publicly traded Avingtrans shares are worth a total of UK£88.7m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Avingtrans boasts net cash, so it's fair to say it does not have a heavy debt load!
It was also good to see that despite losing money on the EBIT line last year, Avingtrans turned things around in the last 12 months, delivering and EBIT of UK£3.7m. 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 Avingtrans'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. Avingtrans 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. Happily for any shareholders, Avingtrans actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While Avingtrans does have more liabilities than liquid assets, it also has net cash of UK£147.0k. The cherry on top was that in converted 157% of that EBIT to free cash flow, bringing in UK£5.8m. So is Avingtrans's debt a risk? It doesn't seem so to us. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Avingtrans insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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