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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Porvair plc (LON:PRV) does use debt in its business. 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Porvair's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of November 2020 Porvair had UK£10.7m of debt, an increase on UK£8.88m, over one year. However, its balance sheet shows it holds UK£15.6m in cash, so it actually has UK£4.88m net cash.
A Look At Porvair's Liabilities
We can see from the most recent balance sheet that Porvair had liabilities of UK£28.1m falling due within a year, and liabilities of UK£39.4m due beyond that. Offsetting these obligations, it had cash of UK£15.6m as well as receivables valued at UK£20.0m due within 12 months. So its liabilities total UK£31.9m more than the combination of its cash and short-term receivables.
Of course, Porvair has a market capitalization of UK£269.7m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Porvair also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the bad news is that Porvair has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Porvair'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Porvair 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, Porvair 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.
Although Porvair's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£4.88m. So we don't have any problem with Porvair's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Porvair, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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