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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Praemium Limited (ASX:PPS) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Praemium's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2021 Praemium had AU$13.6m of debt, an increase on none, over one year. However, it does have AU$26.7m in cash offsetting this, leading to net cash of AU$13.1m.
How Healthy Is Praemium's Balance Sheet?
The latest balance sheet data shows that Praemium had liabilities of AU$19.8m due within a year, and liabilities of AU$11.9m falling due after that. Offsetting these obligations, it had cash of AU$26.7m as well as receivables valued at AU$7.79m due within 12 months. So it can boast AU$2.86m more liquid assets than total liabilities.
This state of affairs indicates that Praemium's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the AU$551.8m company is short on cash, but still worth keeping an eye on the balance sheet. Simply put, the fact that Praemium has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Praemium's saving grace is its low debt levels, because its EBIT has tanked 66% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Praemium can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Praemium 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. In the last three years, Praemium's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Praemium has net cash of AU$13.1m, as well as more liquid assets than liabilities. So we are not troubled with Praemium's debt use. 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. We've identified 3 warning signs with Praemium , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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