The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Vertu Motors plc (LON:VTU) does carry debt. 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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Vertu Motors Carry?
The image below, which you can click on for greater detail, shows that at August 2019 Vertu Motors had debt of UK£66.5m, up from UK£55.6m in one year. But it also has UK£72.7m in cash to offset that, meaning it has UK£6.17m net cash.
A Look At Vertu Motors's Liabilities
We can see from the most recent balance sheet that Vertu Motors had liabilities of UK£715.2m falling due within a year, and liabilities of UK£132.5m due beyond that. Offsetting these obligations, it had cash of UK£72.7m as well as receivables valued at UK£60.1m due within 12 months. So it has liabilities totalling UK£714.9m more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the UK£75.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Vertu Motors would likely require a major re-capitalisation if it had to pay its creditors today. Given that Vertu Motors has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
Importantly Vertu Motors's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. 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 Vertu Motors'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 company can only pay off debt with cold hard cash, not accounting profits. While Vertu Motors 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. Looking at the most recent three years, Vertu Motors recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Although Vertu Motors'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£6.17m. Despite the cash, we do find Vertu Motors's level of total liabilities concerning, so we're not particularly comfortable with the stock. 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 instance, we've identified 3 warning signs for Vertu Motors that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.
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