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 can see that Information Services Corporation (TSE:ISV) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Information Services's Net Debt?
The image below, which you can click on for greater detail, shows that Information Services had debt of CA$19.0m at the end of June 2019, a reduction from CA$20.8m over a year. However, its balance sheet shows it holds CA$19.6m in cash, so it actually has CA$624.0k net cash.
A Look At Information Services's Liabilities
Zooming in on the latest balance sheet data, we can see that Information Services had liabilities of CA$24.9m due within 12 months and liabilities of CA$34.1m due beyond that. On the other hand, it had cash of CA$19.6m and CA$12.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$27.1m.
Since publicly traded Information Services shares are worth a total of CA$281.2m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Information Services also has more cash than debt, so we're pretty confident it can manage its debt safely.
Fortunately, Information Services grew its EBIT by 4.8% in the last year, making that debt load look even more manageable. 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 Information Services 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. While Information Services 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. Happily for any shareholders, Information Services actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
We could understand if investors are concerned about Information Services's liabilities, but we can be reassured by the fact it has has net cash of CA$624k. And it impressed us with free cash flow of CA$22m, being 102% of its EBIT. So we don't think Information Services's use of debt is risky. We'd be motivated to research the stock further if we found out that Information Services insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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