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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 note that Grafenia Plc (LON:GRA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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, 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.
How Much Debt Does Grafenia Carry?
As you can see below, at the end of September 2020, Grafenia had UK£3.18m of debt, up from UK£81.0k a year ago. Click the image for more detail. However, it does have UK£3.68m in cash offsetting this, leading to net cash of UK£504.0k.
A Look At Grafenia's Liabilities
The latest balance sheet data shows that Grafenia had liabilities of UK£3.60m due within a year, and liabilities of UK£6.84m falling due after that. Offsetting this, it had UK£3.68m in cash and UK£2.24m in receivables that were due within 12 months. So it has liabilities totalling UK£4.52m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Grafenia is worth UK£7.73m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Grafenia boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Grafenia 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.
In the last year Grafenia had a loss before interest and tax, and actually shrunk its revenue by 23%, to UK£12m. That makes us nervous, to say the least.
So How Risky Is Grafenia?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And in the last year Grafenia had an earnings before interest and tax (EBIT) loss, truth be told. Indeed, in that time it burnt through UK£942k of cash and made a loss of UK£3.5m. Given it only has net cash of UK£504.0k, the company may need to raise more capital if it doesn't reach break-even soon. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Grafenia you should be aware of, and 1 of them doesn't sit too well with us.
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.
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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