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 XRF Scientific Limited (ASX:XRF) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does XRF Scientific Carry?
As you can see below, at the end of June 2019, XRF Scientific had AU$4.24m of debt, up from AU$3.26m a year ago. Click the image for more detail. However, it also had AU$3.24m in cash, and so its net debt is AU$998.6k.
How Healthy Is XRF Scientific's Balance Sheet?
According to the last reported balance sheet, XRF Scientific had liabilities of AU$6.03m due within 12 months, and liabilities of AU$1.88m due beyond 12 months. On the other hand, it had cash of AU$3.24m and AU$4.07m worth of receivables due within a year. So it has liabilities totalling AU$602.3k more than its cash and near-term receivables, combined.
Having regard to XRF Scientific's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the AU$31.4m company is short on cash, but still worth keeping an eye on the balance sheet.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
XRF Scientific's net debt is only 0.25 times its EBITDA. And its EBIT easily covers its interest expense, being 31.5 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, XRF Scientific grew its EBIT by 89% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, XRF Scientific basically broke even on a free cash flow basis. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
XRF Scientific's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like XRF Scientific is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We'd be motivated to research the stock further if we found out that XRF Scientific insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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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. Thank you for reading.