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 can see that MLS Innovation Inc. (ATH:MLS) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does MLS Innovation Carry?
As you can see below, MLS Innovation had €12.2m of debt at December 2018, down from €12.9m a year prior. However, because it has a cash reserve of €6.06m, its net debt is less, at about €6.11m.
A Look At MLS Innovation's Liabilities
According to the last reported balance sheet, MLS Innovation had liabilities of €13.8m due within 12 months, and liabilities of €11.0m due beyond 12 months. On the other hand, it had cash of €6.06m and €8.61m worth of receivables due within a year. So it has liabilities totalling €10.1m more than its cash and near-term receivables, combined.
Given MLS Innovation has a market capitalization of €58.1m, 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.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Even though MLS Innovation's debt is only 2.3, its interest cover is really very low at 2.2. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Sadly, MLS Innovation's EBIT actually dropped 9.6% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MLS Innovation can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, MLS Innovation 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 MLS Innovation's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its level of total liabilities is not so bad. Overall, we think it's fair to say that MLS Innovation has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Given our hesitation about the stock, it would be good to know if MLS Innovation insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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