Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Warpaint London PLC (LON:W7L) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Warpaint London's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Warpaint London had UK£2.13m of debt, an increase on UK£1.40m, over one year. However, it does have UK£4.04m in cash offsetting this, leading to net cash of UK£1.91m.
How Strong Is Warpaint London's Balance Sheet?
We can see from the most recent balance sheet that Warpaint London had liabilities of UK£6.69m falling due within a year, and liabilities of UK£2.35m due beyond that. On the other hand, it had cash of UK£4.04m and UK£11.5m worth of receivables due within a year. So it actually has UK£6.51m more liquid assets than total liabilities.
This surplus suggests that Warpaint London has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Warpaint London boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Warpaint London has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Warpaint London'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. Warpaint London 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 most recent three years, Warpaint London recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Warpaint London has net cash of UK£1.9m, as well as more liquid assets than liabilities. So we are not troubled with Warpaint London's debt use. Given Warpaint London has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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