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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Perceptron, Inc. (NASDAQ:PRCP) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Perceptron's Net Debt?
As you can see below, Perceptron had US$17.0k of debt at March 2019, down from US$1.77m a year prior. However, it does have US$6.17m in cash offsetting this, leading to net cash of US$6.15m.
How Strong Is Perceptron's Balance Sheet?
According to the last reported balance sheet, Perceptron had liabilities of US$19.7m due within 12 months, and liabilities of US$2.52m due beyond 12 months. Offsetting this, it had US$6.17m in cash and US$32.0m in receivables that were due within 12 months. So it can boast US$16.0m more liquid assets than total liabilities.
This luscious liquidity implies that Perceptron's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, Perceptron boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Perceptron's load is not too heavy, because its EBIT was down 47% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Perceptron 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Perceptron may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Perceptron created free cash flow amounting to 7.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While it is always sensible to investigate a company's debt, in this case Perceptron has US$6.2m in net cash and a decent-looking balance sheet. So we are not troubled with Perceptron's debt use. We'd be motivated to research the stock further if we found out that Perceptron insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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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.