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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 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 note that Allergy Therapeutics plc (LON:AGY) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Allergy Therapeutics's Net Debt?
As you can see below, Allergy Therapeutics had UK£3.41m of debt at June 2021, down from UK£3.76m a year prior. However, it does have UK£40.3m in cash offsetting this, leading to net cash of UK£36.9m.
A Look At Allergy Therapeutics' Liabilities
We can see from the most recent balance sheet that Allergy Therapeutics had liabilities of UK£18.2m falling due within a year, and liabilities of UK£21.3m due beyond that. Offsetting these obligations, it had cash of UK£40.3m as well as receivables valued at UK£4.62m due within 12 months. So it can boast UK£5.34m more liquid assets than total liabilities.
This surplus suggests that Allergy Therapeutics has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Allergy Therapeutics has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Allergy Therapeutics's load is not too heavy, because its EBIT was down 21% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Allergy Therapeutics'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Allergy Therapeutics 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 last two years, Allergy Therapeutics actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While we empathize with investors who find debt concerning, you should keep in mind that Allergy Therapeutics has net cash of UK£36.9m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of UK£5.8m, being 177% of its EBIT. So we are not troubled with Allergy Therapeutics's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Allergy Therapeutics is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...
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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