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Is First Derivatives (LON:FDP) 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.' 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 can see that First Derivatives plc (LON:FDP) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for First Derivatives

How Much Debt Does First Derivatives Carry?

As you can see below, at the end of February 2019, First Derivatives had UK£34.9m of debt, up from UK£28.6m a year ago. Click the image for more detail. However, it does have UK£18.8m in cash offsetting this, leading to net debt of about UK£16.1m.

AIM:FDP Historical Debt, September 16th 2019

A Look At First Derivatives's Liabilities

According to the last reported balance sheet, First Derivatives had liabilities of UK£120.6m due within 12 months, and liabilities of UK£14.4m due beyond 12 months. On the other hand, it had cash of UK£18.8m and UK£53.4m worth of receivables due within a year. So its liabilities total UK£62.8m more than the combination of its cash and short-term receivables.

Given First Derivatives has a market capitalization of UK£621.8m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

First Derivatives has a low net debt to EBITDA ratio of only 0.60. And its EBIT easily covers its interest expense, being 15.8 times the size. So we're pretty relaxed about its super-conservative use of debt. Also positive, First Derivatives grew its EBIT by 24% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine First Derivatives's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, First Derivatives produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, First Derivatives's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, First Derivatives seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of First Derivatives's earnings per share history 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.

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.