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These 4 Measures Indicate That UCW (ASX:UCW) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that UCW Limited (ASX:UCW) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for UCW

How Much Debt Does UCW Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 UCW had AU$4.17m of debt, an increase on AU$1.20m, over one year. But on the other hand it also has AU$6.63m in cash, leading to a AU$2.47m net cash position.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At UCW's Liabilities

The latest balance sheet data shows that UCW had liabilities of AU$12.3m due within a year, and liabilities of AU$17.0m falling due after that. Offsetting these obligations, it had cash of AU$6.63m as well as receivables valued at AU$1.04m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$21.6m.

Given this deficit is actually higher than the company's market capitalization of AU$15.9m, we think shareholders really should watch UCW's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. UCW boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Pleasingly, UCW is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 149% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since UCW will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. UCW 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. Happily for any shareholders, UCW actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although UCW's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$2.47m. The cherry on top was that in converted 179% of that EBIT to free cash flow, bringing in AU$6.2m. So we don't have any problem with UCW's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that UCW is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

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. 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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