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 Pattern S.p.A. (BIT:PTR) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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. 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.
How Much Debt Does Pattern Carry?
The chart below, which you can click on for greater detail, shows that Pattern had €4.01m in debt in June 2019; about the same as the year before. But on the other hand it also has €8.09m in cash, leading to a €4.08m net cash position.
How Strong Is Pattern's Balance Sheet?
We can see from the most recent balance sheet that Pattern had liabilities of €16.7m falling due within a year, and liabilities of €4.04m due beyond that. Offsetting these obligations, it had cash of €8.09m as well as receivables valued at €6.38m due within 12 months. So its liabilities total €6.28m more than the combination of its cash and short-term receivables.
Of course, Pattern has a market capitalization of €46.4m, so these liabilities are probably manageable. 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, Pattern also has more cash than debt, so we're pretty confident it can manage its debt safely.
In addition to that, we're happy to report that Pattern has boosted its EBIT by 63%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Pattern'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Pattern 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 two years, Pattern 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.
Although Pattern's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of €4.08m. The cherry on top was that in converted 124% of that EBIT to free cash flow, bringing in €7.7m. So we don't think Pattern's use of debt is risky. 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. For example, we've discovered 3 warning signs for Pattern that you should be aware of before investing here.
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.
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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