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 Credit Intelligence Limited (ASX:CI1) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Credit Intelligence's Net Debt?
As you can see below, at the end of June 2019, Credit Intelligence had AU$2.53m of debt, up from none a year ago. Click the image for more detail. However, it does have AU$3.51m in cash offsetting this, leading to net cash of AU$987.2k.
A Look At Credit Intelligence's Liabilities
We can see from the most recent balance sheet that Credit Intelligence had liabilities of AU$3.36m falling due within a year, and liabilities of AU$3.02m due beyond that. On the other hand, it had cash of AU$3.51m and AU$5.23m worth of receivables due within a year. So it can boast AU$2.36m more liquid assets than total liabilities.
This surplus suggests that Credit Intelligence has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Credit Intelligence 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 Credit Intelligence if management cannot prevent a repeat of the 57% cut to EBIT 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 ultimately the future profitability of the business will decide if Credit Intelligence 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Credit Intelligence 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. During the last three years, Credit Intelligence produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Credit Intelligence has net cash of AU$987.2k, as well as more liquid assets than liabilities. So we don't have any problem with Credit Intelligence's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Credit Intelligence has 6 warning signs (and 1 which is a bit unpleasant) we think you should know about.
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.
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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