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. 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 FINEOS Corporation Holdings plc (ASX:FCL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.
What Is FINEOS Corporation Holdings's Debt?
The image below, which you can click on for greater detail, shows that FINEOS Corporation Holdings had debt of €15.0m at the end of June 2019, a reduction from €19.3m over a year. On the flip side, it has €6.90m in cash leading to net debt of about €8.10m.
A Look At FINEOS Corporation Holdings's Liabilities
We can see from the most recent balance sheet that FINEOS Corporation Holdings had liabilities of €23.6m falling due within a year, and liabilities of €28.0m due beyond that. Offsetting this, it had €6.90m in cash and €13.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €31.4m.
Since publicly traded FINEOS Corporation Holdings shares are worth a total of €487.4m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
FINEOS Corporation Holdings has a rather high debt to EBITDA ratio of 5.8 which suggests a meaningful debt load. However, its interest coverage of 2.9 is reasonably strong, which is a good sign. Worse, FINEOS Corporation Holdings's EBIT was down 80% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 FINEOS Corporation Holdings'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. So we always check how much of that EBIT is translated into free cash flow. During the last two years, FINEOS Corporation Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both FINEOS Corporation Holdings's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. We're quite clear that we consider FINEOS Corporation Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. While FINEOS Corporation Holdings didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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.
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If you spot an error that warrants correction, please contact the editor at email@example.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.