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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, The Character Group plc (LON:CCT) does carry debt. But is this debt a concern to shareholders?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Character Group's Debt?
As you can see below, Character Group had UK£3.17m of debt at August 2020, down from UK£23.5m a year prior. However, its balance sheet shows it holds UK£22.3m in cash, so it actually has UK£19.1m net cash.
A Look At Character Group's Liabilities
Zooming in on the latest balance sheet data, we can see that Character Group had liabilities of UK£33.2m due within 12 months and liabilities of UK£1.57m due beyond that. Offsetting these obligations, it had cash of UK£22.3m as well as receivables valued at UK£21.8m due within 12 months. So it can boast UK£9.30m more liquid assets than total liabilities.
This surplus suggests that Character Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Character Group boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Character Group's load is not too heavy, because its EBIT was down 54% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Character Group'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 company can only pay off debt with cold hard cash, not accounting profits. While Character Group 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. Over the last three years, Character Group 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 we empathize with investors who find debt concerning, you should keep in mind that Character Group has net cash of UK£19.1m, as well as more liquid assets than liabilities. The cherry on top was that in converted 104% of that EBIT to free cash flow, bringing in UK£15m. So we don't have any problem with Character Group's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Character Group (including 1 which can't be ignored) .
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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