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 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 can see that AIREA plc (LON:AIEA) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does AIREA Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 AIREA had UK£3.90m of debt, an increase on UK£1.55m, over one year. But on the other hand it also has UK£6.45m in cash, leading to a UK£2.55m net cash position.
How Strong Is AIREA's Balance Sheet?
We can see from the most recent balance sheet that AIREA had liabilities of UK£3.60m falling due within a year, and liabilities of UK£9.03m due beyond that. Offsetting these obligations, it had cash of UK£6.45m as well as receivables valued at UK£1.92m due within 12 months. So it has liabilities totalling UK£4.3m more than its cash and near-term receivables, combined.
This deficit isn't so bad because AIREA is worth UK£10.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, AIREA also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for AIREA if management cannot prevent a repeat of the 58% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 AIREA will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. AIREA 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, AIREA actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although AIREA's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£2.55m. The cherry on top was that in converted 111% of that EBIT to free cash flow, bringing in UK£3.4m. So we don't have any problem with AIREA'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 AIREA is showing 3 warning signs in our investment analysis , you should know about...
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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