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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 can see that Noxopharm Limited (ASX:NOX) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Noxopharm Carry?
You can click the graphic below for the historical numbers, but it shows that Noxopharm had AU$3.75m of debt in December 2020, down from AU$7.46m, one year before. But it also has AU$22.9m in cash to offset that, meaning it has AU$19.1m net cash.
A Look At Noxopharm's Liabilities
According to the last reported balance sheet, Noxopharm had liabilities of AU$6.01m due within 12 months, and liabilities of AU$361.1k due beyond 12 months. Offsetting these obligations, it had cash of AU$22.9m as well as receivables valued at AU$6.09m due within 12 months. So it actually has AU$22.6m more liquid assets than total liabilities.
This surplus suggests that Noxopharm has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Noxopharm boasts net cash, so it's fair to say it does not have a heavy debt load! The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Noxopharm will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Since Noxopharm doesn't have significant operating revenue, shareholders may be hoping it comes up with a great new product, before it runs out of money.
So How Risky Is Noxopharm?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that Noxopharm had an earnings before interest and tax (EBIT) loss, over the last year. And over the same period it saw negative free cash outflow of AU$12m and booked a AU$45k accounting loss. Given it only has net cash of AU$19.1m, the company may need to raise more capital if it doesn't reach break-even soon. The good news for shareholders is that Noxopharm has dazzling revenue growth, so there's a very good chance it can boost its free cash flow in the years to come. While unprofitable companies can be risky, they can also grow hard and fast in those pre-profit years. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Noxopharm (at least 1 which is significant) , and understanding them should be part of your investment process.
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.
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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