Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk'. 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, Volex plc (LON:VLX) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Volex's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Volex had US$9.96m of debt, an increase on none, over one year. But it also has US$17.9m in cash to offset that, meaning it has US$7.92m net cash.
A Look At Volex's Liabilities
The latest balance sheet data shows that Volex had liabilities of US$95.6m due within a year, and liabilities of US$14.6m falling due after that. On the other hand, it had cash of US$17.9m and US$85.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.82m.
Given Volex has a market capitalization of US$237.6m, 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, Volex also has more cash than debt, so we're pretty confident it can manage its debt safely.
Even more impressive was the fact that Volex grew its EBIT by 136% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Volex's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Volex 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. In the last three years, Volex's free cash flow amounted to 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Volex has US$7.92m in net cash. And we liked the look of last year's 136% year-on-year EBIT growth. So we don't think Volex's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Volex .
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.
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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