David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Fulcrum Utility Services Limited (LON:FCRM) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Fulcrum Utility Services's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Fulcrum Utility Services had debt of UK£3.00m, up from none in one year. But it also has UK£6.82m in cash to offset that, meaning it has UK£3.82m net cash.
How Strong Is Fulcrum Utility Services's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Fulcrum Utility Services had liabilities of UK£40.4m due within 12 months and liabilities of UK£5.19m due beyond that. Offsetting these obligations, it had cash of UK£6.82m as well as receivables valued at UK£15.5m due within 12 months. So its liabilities total UK£23.2m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Fulcrum Utility Services has a market capitalization of UK£53.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Fulcrum Utility Services also has more cash than debt, so we're pretty confident it can manage its debt safely.
On the other hand, Fulcrum Utility Services saw its EBIT drop by 4.3% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Fulcrum Utility Services'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 company can only pay off debt with cold hard cash, not accounting profits. Fulcrum Utility Services 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. Looking at the most recent three years, Fulcrum Utility Services recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Fulcrum Utility Services does have more liabilities than liquid assets, it also has net cash of UK£3.82m. So we are not troubled with Fulcrum Utility Services's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Fulcrum Utility Services 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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