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 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 Baby Bunting Group Limited (ASX:BBN) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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 Baby Bunting Group Carry?
As you can see below, Baby Bunting Group had AU$3.13m of debt at June 2019, down from AU$10.8m a year prior. However, it does have AU$5.84m in cash offsetting this, leading to net cash of AU$2.71m.
A Look At Baby Bunting Group's Liabilities
We can see from the most recent balance sheet that Baby Bunting Group had liabilities of AU$53.8m falling due within a year, and liabilities of AU$7.06m due beyond that. Offsetting this, it had AU$5.84m in cash and AU$4.10m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$50.9m.
Since publicly traded Baby Bunting Group shares are worth a total of AU$375.5m, 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. While it does have liabilities worth noting, Baby Bunting Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Baby Bunting Group grew its EBIT by 49% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Baby Bunting Group can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. Baby Bunting Group 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. In the last three years, Baby Bunting Group's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Although Baby Bunting Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$2.7m. And we liked the look of last year's 49% year-on-year EBIT growth. So we don't think Baby Bunting Group's use of debt is risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Baby Bunting Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.