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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies IKONICS Corporation (NASDAQ:IKNX) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does IKONICS Carry?
As you can see below, IKONICS had US$2.82m of debt at December 2019, down from US$2.95m a year prior. However, it does have US$3.17m in cash offsetting this, leading to net cash of US$347.0k.
A Look At IKONICS's Liabilities
According to the last reported balance sheet, IKONICS had liabilities of US$1.93m due within 12 months, and liabilities of US$2.69m due beyond 12 months. Offsetting this, it had US$3.17m in cash and US$2.44m in receivables that were due within 12 months. So it actually has US$981.9k more liquid assets than total liabilities.
It's good to see that IKONICS has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that IKONICS has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since IKONICS 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.
In the last year IKONICS had negative earnings before interest and tax, and actually shrunk its revenue by 3.3%, to US$18m. We would much prefer see growth.
So How Risky Is IKONICS?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And in the last year IKONICS had negative earnings before interest and tax (EBIT), truth be told. Indeed, in that time it burnt through US$975k of cash and made a loss of US$814k. While this does make the company a bit risky, it's important to remember it has net cash of US$347.0k. That means it could keep spending at its current rate for more than two years. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with IKONICS , and understanding them should be part of your investment process.
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.
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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