Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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 Cake Box Holdings plc (LON:CBOX) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Cake Box Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Cake Box Holdings had debt of UK£2.12m, up from UK£1.64m in one year. However, it does have UK£3.08m in cash offsetting this, leading to net cash of UK£965.5k.
A Look At Cake Box Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Cake Box Holdings had liabilities of UK£2.49m due within 12 months and liabilities of UK£2.16m due beyond that. Offsetting these obligations, it had cash of UK£3.08m as well as receivables valued at UK£1.53m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Cake Box Holdings's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the UK£68.7m company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Cake Box Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
And we also note warmly that Cake Box Holdings grew its EBIT by 18% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Cake Box Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Cake Box Holdings 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. Looking at the most recent three years, Cake Box Holdings recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Cake Box Holdings has UK£965.5k in net cash. And it impressed us with its EBIT growth of 18% over the last year. So is Cake Box Holdings'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 Cake Box Holdings 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.
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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.