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. As with many other companies FW Thorpe Plc (LON:TFW) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is FW Thorpe's Debt?
The image below, which you can click on for greater detail, shows that FW Thorpe had debt of UK£2.14m at the end of June 2019, a reduction from UK£2.34m over a year. However, it does have UK£57.7m in cash offsetting this, leading to net cash of UK£55.5m.
How Healthy Is FW Thorpe's Balance Sheet?
The latest balance sheet data shows that FW Thorpe had liabilities of UK£23.8m due within a year, and liabilities of UK£15.9m falling due after that. Offsetting this, it had UK£57.7m in cash and UK£20.2m in receivables that were due within 12 months. So it can boast UK£38.1m more liquid assets than total liabilities.
This surplus suggests that FW Thorpe has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that FW Thorpe has more cash than debt is arguably a good indication that it can manage its debt safely.
On the other hand, FW Thorpe saw its EBIT drop by 9.3% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if FW Thorpe can strengthen its balance sheet over time. 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. FW Thorpe 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 most recent three years, FW Thorpe recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case FW Thorpe has UK£55.5m in net cash and a decent-looking balance sheet. So we don't have any problem with FW Thorpe's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of FW Thorpe's earnings per share history for free.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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