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Is Crescita Therapeutics (TSE:CTX) Using Too Much Debt?

Simply Wall St

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Crescita Therapeutics Inc. (TSE:CTX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Crescita Therapeutics

What Is Crescita Therapeutics's Net Debt?

The chart below, which you can click on for greater detail, shows that Crescita Therapeutics had CA$4.45m in debt in September 2019; about the same as the year before. But it also has CA$13.1m in cash to offset that, meaning it has CA$8.62m net cash.

TSX:CTX Historical Debt, November 18th 2019

A Look At Crescita Therapeutics's Liabilities

The latest balance sheet data shows that Crescita Therapeutics had liabilities of CA$5.92m due within a year, and liabilities of CA$5.00m falling due after that. On the other hand, it had cash of CA$13.1m and CA$3.86m worth of receivables due within a year. So it actually has CA$6.00m more liquid assets than total liabilities.

This surplus liquidity suggests that Crescita Therapeutics's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that Crescita Therapeutics has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Crescita Therapeutics made a loss at the EBIT level, last year, it was also good to see that it generated CA$6.9m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Crescita Therapeutics's earnings that will influence how the balance sheet holds up in the future. 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. Crescita Therapeutics 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. Over the last year, Crescita Therapeutics recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Crescita Therapeutics has CA$8.62m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 82% of that EBIT to free cash flow, bringing in CA$5.7m. So is Crescita Therapeutics's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Crescita Therapeutics, you may well want to click here to check an interactive graph of its earnings per share history.

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.

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 editorial-team@simplywallst.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. Thank you for reading.