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.' 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. Importantly, Instem plc (LON:INS) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Instem's Net Debt?
As you can see below, Instem had UK£52.0k of debt at December 2018, down from UK£83.0k a year prior. But it also has UK£3.57m in cash to offset that, meaning it has UK£3.52m net cash.
How Healthy Is Instem's Balance Sheet?
We can see from the most recent balance sheet that Instem had liabilities of UK£11.2m falling due within a year, and liabilities of UK£2.52m due beyond that. Offsetting these obligations, it had cash of UK£3.57m as well as receivables valued at UK£7.61m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£2.57m.
Given Instem has a market capitalization of UK£65.2m, 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, Instem boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Instem grew its EBIT by 217% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Instem's ability to maintain a healthy balance sheet going forward. 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. Instem 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. In the last two years, Instem created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Instem has UK£3.5m in net cash. And it impressed us with its EBIT growth of 217% over the last year. So we don't think Instem'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 Instem insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.