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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Psychemedics Corporation (NASDAQ:PMD) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Psychemedics Carry?
As you can see below, Psychemedics had US$1.42m of debt at June 2019, down from US$2.90m a year prior. But it also has US$7.10m in cash to offset that, meaning it has US$5.68m net cash.
A Look At Psychemedics's Liabilities
We can see from the most recent balance sheet that Psychemedics had liabilities of US$4.20m falling due within a year, and liabilities of US$2.46m due beyond that. Offsetting this, it had US$7.10m in cash and US$4.53m in receivables that were due within 12 months. So it can boast US$4.97m more liquid assets than total liabilities.
This surplus suggests that Psychemedics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Psychemedics boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Psychemedics's load is not too heavy, because its EBIT was down 27% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Psychemedics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Psychemedics 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, Psychemedics generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Psychemedics has net cash of US$5.7m, as well as more liquid assets than liabilities. The cherry on top was that in converted 83% of that EBIT to free cash flow, bringing in US$4.8m. So we don't think Psychemedics's use of debt is risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Psychemedics insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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