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. We note that Netcall plc (LON:NET) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Netcall's Net Debt?
The chart below, which you can click on for greater detail, shows that Netcall had UK£6.75m in debt in June 2020; about the same as the year before. But it also has UK£12.7m in cash to offset that, meaning it has UK£5.97m net cash.
A Look At Netcall's Liabilities
According to the last reported balance sheet, Netcall had liabilities of UK£18.9m due within 12 months, and liabilities of UK£8.59m due beyond 12 months. Offsetting these obligations, it had cash of UK£12.7m as well as receivables valued at UK£4.55m due within 12 months. So it has liabilities totalling UK£10.2m more than its cash and near-term receivables, combined.
Given Netcall has a market capitalization of UK£72.2m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Netcall also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, Netcall's EBIT fell a jaw-dropping 33% in the last twelve months. 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 Netcall 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. While Netcall 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. Happily for any shareholders, Netcall actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Netcall's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£5.97m. The cherry on top was that in converted 211% of that EBIT to free cash flow, bringing in UK£7.6m. So we are not troubled with Netcall's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Netcall you should be aware of, and 1 of them is concerning.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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