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Here's Why Proton Power Systems (LON:PPS) Can Afford Some Debt

Simply Wall St

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Proton Power Systems plc (LON:PPS) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Proton Power Systems

How Much Debt Does Proton Power Systems Carry?

The image below, which you can click on for greater detail, shows that at December 2018 Proton Power Systems had debt of UK£58.3m, up from UK£47.5m in one year. And it doesn't have much cash, so its net debt is about the same.

AIM:PPS Historical Debt, August 21st 2019

How Healthy Is Proton Power Systems's Balance Sheet?

According to the last reported balance sheet, Proton Power Systems had liabilities of UK£1.95m due within 12 months, and liabilities of UK£96.5m due beyond 12 months. On the other hand, it had cash of UK£841.0k and UK£355.0k worth of receivables due within a year. So it has liabilities totalling UK£97.3m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of UK£155.6m, so it does suggest shareholders should keep an eye on Proton Power Systems's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But it is Proton Power Systems's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Over 12 months, Proton Power Systems saw its revenue drop to UK£822k, which is a fall of 26%. To be frank that doesn't bode well.

Caveat Emptor

While Proton Power Systems's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost UK£5.0m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through UK£6.2m of cash over the last year. So suffice it to say we do consider the stock to be risky. For riskier companies like Proton Power Systems I always like to keep an eye on the long term profit and revenue trends. Fortunately, you can click to see our interactive graph of its profit, revenue, and operating cashflow.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.