Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies EXFO Inc. (TSE:EXF) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 EXFO's Net Debt?
You can click the graphic below for the historical numbers, but it shows that EXFO had US$11.5m of debt in May 2019, down from US$20.5m, one year before. But on the other hand it also has US$15.3m in cash, leading to a US$3.86m net cash position.
How Healthy Is EXFO's Balance Sheet?
The latest balance sheet data shows that EXFO had liabilities of US$85.3m due within a year, and liabilities of US$20.1m falling due after that. On the other hand, it had cash of US$15.3m and US$59.2m worth of receivables due within a year. So it has liabilities totalling US$30.8m more than its cash and near-term receivables, combined.
Since publicly traded EXFO shares are worth a total of US$204.5m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, EXFO also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, EXFO grew its EBIT by 57% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if EXFO can strengthen its balance sheet over time. 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. While EXFO has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, EXFO produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While EXFO does have more liabilities than liquid assets, it also has net cash of US$3.9m. And it impressed us with its EBIT growth of 57% over the last year. So we don't think EXFO's use of debt is risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that EXFO 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.
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