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 PolyNovo Limited (ASX:PNV) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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.
What Is PolyNovo's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 PolyNovo had AU$7.29m of debt, an increase on none, over one year. However, its balance sheet shows it holds AU$11.7m in cash, so it actually has AU$4.41m net cash.
How Strong Is PolyNovo's Balance Sheet?
We can see from the most recent balance sheet that PolyNovo had liabilities of AU$9.47m falling due within a year, and liabilities of AU$4.57m due beyond that. Offsetting these obligations, it had cash of AU$11.7m as well as receivables valued at AU$3.92m due within 12 months. So it actually has AU$1.57m more liquid assets than total liabilities.
Having regard to PolyNovo's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the AU$1.65b company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that PolyNovo has more cash than debt is arguably a good indication that it can manage its debt safely. 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 PolyNovo 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.
Over 12 months, PolyNovo reported revenue of AU$22m, which is a gain of 58%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.
So How Risky Is PolyNovo?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And the fact is that over the last twelve months PolyNovo lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of AU$9.3m and booked a AU$4.2m accounting loss. With only AU$4.41m on the balance sheet, it would appear that its going to need to raise capital again soon. PolyNovo's revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. By investing before those profits, shareholders take on more risk in the hope of bigger rewards. For riskier companies like PolyNovo I always like to keep an eye on whether insiders are buying or selling. So click here if you want to find out for yourself.
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. 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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