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.' 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. We can see that Telit Communications PLC (LON:TCM) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Telit Communications Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Telit Communications had US$32.7m of debt, an increase on US$30.8m, over one year. However, it does have US$88.3m in cash offsetting this, leading to net cash of US$55.6m.
A Look At Telit Communications's Liabilities
We can see from the most recent balance sheet that Telit Communications had liabilities of US$126.2m falling due within a year, and liabilities of US$30.9m due beyond that. Offsetting these obligations, it had cash of US$88.3m as well as receivables valued at US$80.2m due within 12 months. So it actually has US$11.3m more liquid assets than total liabilities.
This surplus suggests that Telit Communications has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Telit Communications has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, Telit Communications grew its EBIT by 1,474% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Telit Communications 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, a company can only pay off debt with cold hard cash, not accounting profits. Telit Communications 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. During the last two years, Telit Communications burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While it is always sensible to investigate a company's debt, in this case Telit Communications has US$55.6m in net cash and a decent-looking balance sheet. And we liked the look of last year's 1,474% year-on-year EBIT growth. So we are not troubled with Telit Communications'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 Telit Communications is showing 2 warning signs in our investment analysis , 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.
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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