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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.' 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, Headlam Group plc (LON:HEAD) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Headlam Group's Debt?
The image below, which you can click on for greater detail, shows that Headlam Group had debt of UK£7.50m at the end of December 2021, a reduction from UK£9.20m over a year. However, its balance sheet shows it holds UK£61.2m in cash, so it actually has UK£53.7m net cash.
How Healthy Is Headlam Group's Balance Sheet?
According to the last reported balance sheet, Headlam Group had liabilities of UK£191.1m due within 12 months, and liabilities of UK£49.3m due beyond 12 months. Offsetting these obligations, it had cash of UK£61.2m as well as receivables valued at UK£108.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£70.8m.
Headlam Group has a market capitalization of UK£276.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Headlam Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, Headlam Group grew its EBIT by 159% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Headlam Group 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Headlam Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Headlam Group recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Although Headlam Group'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£53.7m. And it impressed us with free cash flow of UK£6.9m, being 86% of its EBIT. So we don't think Headlam Group's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Headlam Group you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.