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 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. As with many other companies Surgical Innovations Group plc (LON:SUN) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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, 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.
What Is Surgical Innovations Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Surgical Innovations Group had UK£1.96m of debt in June 2019, down from UK£2.28m, one year before. But on the other hand it also has UK£2.30m in cash, leading to a UK£337.0k net cash position.
How Strong Is Surgical Innovations Group's Balance Sheet?
We can see from the most recent balance sheet that Surgical Innovations Group had liabilities of UK£2.40m falling due within a year, and liabilities of UK£3.09m due beyond that. Offsetting these obligations, it had cash of UK£2.30m as well as receivables valued at UK£2.60m due within 12 months. So it has liabilities totalling UK£590.0k more than its cash and near-term receivables, combined.
Given Surgical Innovations Group has a market capitalization of UK£17.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Surgical Innovations Group boasts net cash, so it's fair to say it does not have a heavy debt load!
Shareholders should be aware that Surgical Innovations Group's EBIT was down 46% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Surgical Innovations Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Surgical Innovations Group 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. Happily for any shareholders, Surgical Innovations Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
We could understand if investors are concerned about Surgical Innovations Group's liabilities, but we can be reassured by the fact it has has net cash of UK£337.0k. The cherry on top was that in converted 189% of that EBIT to free cash flow, bringing in UK£379k. So we don't have any problem with Surgical Innovations Group's use of debt. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Surgical Innovations Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying 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.
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.
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