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. We can see that Ultima United Limited (ASX:UUL) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Ultima United Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2021 Ultima United had AU$2.69m of debt, an increase on AU$2.40m, over one year. But it also has AU$13.0m in cash to offset that, meaning it has AU$10.3m net cash.
How Strong Is Ultima United's Balance Sheet?
According to the last reported balance sheet, Ultima United had liabilities of AU$3.20m due within 12 months, and liabilities of AU$703.8k due beyond 12 months. On the other hand, it had cash of AU$13.0m and AU$44.0k worth of receivables due within a year. So it actually has AU$9.12m more liquid assets than total liabilities.
This surplus liquidity suggests that Ultima United's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Ultima United has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Ultima United will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
It seems likely shareholders hope that Ultima United can significantly advance the business plan before too long, because it doesn't have any significant revenue at the moment.
So How Risky Is Ultima United?
Statistically speaking companies that lose money are riskier than those that make money. And in the last year Ultima United had an earnings before interest and tax (EBIT) loss, truth be told. Indeed, in that time it burnt through AU$99k of cash and made a loss of AU$117k. While this does make the company a bit risky, it's important to remember it has net cash of AU$10.3m. That kitty means the company can keep spending for growth for at least two years, at current rates. Overall, its balance sheet doesn't seem overly risky, at the moment, but we're always cautious until we see the positive free cash flow. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Ultima United is showing 4 warning signs in our investment analysis , and 3 of those are potentially serious...
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.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.