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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 XRF Scientific Limited (ASX:XRF) does use debt in its business. 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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 XRF Scientific Carry?
You can click the graphic below for the historical numbers, but it shows that XRF Scientific had AU$4.61m of debt in June 2021, down from AU$5.18m, one year before. But on the other hand it also has AU$5.26m in cash, leading to a AU$643.1k net cash position.
A Look At XRF Scientific's Liabilities
Zooming in on the latest balance sheet data, we can see that XRF Scientific had liabilities of AU$8.44m due within 12 months and liabilities of AU$832.5k due beyond that. Offsetting these obligations, it had cash of AU$5.26m as well as receivables valued at AU$4.48m due within 12 months. So it actually has AU$464.5k more liquid assets than total liabilities.
Having regard to XRF Scientific's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the AU$84.8m company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that XRF Scientific has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we're happy to report that XRF Scientific has boosted its EBIT by 38%, thus reducing the spectre of future debt repayments. 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 XRF Scientific'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. XRF Scientific 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. During the last three years, XRF Scientific produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case XRF Scientific has AU$643.1k in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 38% over the last year. So we don't think XRF Scientific's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for XRF Scientific you should know about.
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.
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.
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