David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that AVEVA Group plc (LON:AVV) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is AVEVA Group's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 AVEVA Group had debt of UK£20.0m, up from UK£11.9 in one year. But it also has UK£78.6m in cash to offset that, meaning it has UK£58.6m net cash.
A Look At AVEVA Group's Liabilities
The latest balance sheet data shows that AVEVA Group had liabilities of UK£326.0m due within a year, and liabilities of UK£177.2m falling due after that. Offsetting this, it had UK£78.6m in cash and UK£318.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£106.3m.
This state of affairs indicates that AVEVA Group's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the UK£7.96b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, AVEVA Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, AVEVA Group grew its EBIT by 144% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 AVEVA 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. AVEVA 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. Over the last three years, AVEVA Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We could understand if investors are concerned about AVEVA Group's liabilities, but we can be reassured by the fact it has has net cash of UK£58.6m. And it impressed us with free cash flow of UK£105m, being 116% of its EBIT. So is AVEVA Group's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that AVEVA Group is showing 3 warning signs in our investment analysis , you should know about...
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.
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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