The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Robert Walters plc (LON:RWA) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Robert Walters's Net Debt?
The chart below, which you can click on for greater detail, shows that Robert Walters had UK£27.4m in debt in June 2019; about the same as the year before. But it also has UK£81.8m in cash to offset that, meaning it has UK£54.4m net cash.
How Healthy Is Robert Walters's Balance Sheet?
According to the last reported balance sheet, Robert Walters had liabilities of UK£224.4m due within 12 months, and liabilities of UK£66.7m due beyond 12 months. Offsetting this, it had UK£81.8m in cash and UK£242.5m in receivables that were due within 12 months. So it can boast UK£33.2m more liquid assets than total liabilities.
This surplus suggests that Robert Walters has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Robert Walters has more cash than debt is arguably a good indication that it can manage its debt safely.
Also good is that Robert Walters grew its EBIT at 11% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Robert Walters'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Robert Walters 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. Over the last three years, Robert Walters recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company's debt, in this case Robert Walters has UK£54m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in UK£66m. So is Robert Walters's debt a risk? It doesn't seem so to us. Another factor that would give us confidence in Robert Walters would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.