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.' 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 APC Technology Group PLC (LON:APC) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is APC Technology Group's Net Debt?
The image below, which you can click on for greater detail, shows that APC Technology Group had debt of UK£3.59m at the end of February 2019, a reduction from UK£4.27m over a year. On the flip side, it has UK£845.0k in cash leading to net debt of about UK£2.74m.
A Look At APC Technology Group's Liabilities
We can see from the most recent balance sheet that APC Technology Group had liabilities of UK£8.06m falling due within a year, and liabilities of UK£110.0k due beyond that. Offsetting these obligations, it had cash of UK£845.0k as well as receivables valued at UK£3.84m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£3.49m.
APC Technology Group has a market capitalization of UK£13.9m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
APC Technology Group's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 4.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that APC Technology Group's EBIT shot up like bamboo after rain, gaining 47% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if APC Technology 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, APC Technology Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Based on what we've seen APC Technology Group is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about APC Technology Group's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Over time, share prices tend to follow earnings per share, so if you're interested in APC Technology Group, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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