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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Praemium Limited (ASX:PPS) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Praemium's Debt?
The image below, which you can click on for greater detail, shows that Praemium had debt of AU$12.1m at the end of December 2021, a reduction from AU$15.1m over a year. But it also has AU$19.4m in cash to offset that, meaning it has AU$7.28m net cash.
How Healthy Is Praemium's Balance Sheet?
We can see from the most recent balance sheet that Praemium had liabilities of AU$21.9m falling due within a year, and liabilities of AU$9.67m due beyond that. On the other hand, it had cash of AU$19.4m and AU$9.78m worth of receivables due within a year. So it has liabilities totalling AU$2.37m more than its cash and near-term receivables, combined.
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$314.9m company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Praemium also has more cash than debt, so we're pretty confident it can manage its debt safely.
Shareholders should be aware that Praemium's EBIT was down 87% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept 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 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We could understand if investors are concerned about Praemium's liabilities, but we can be reassured by the fact it has has net cash of AU$7.28m. So although we see some areas for improvement, we're not too worried about Praemium's balance sheet. 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 1 warning sign for Praemium 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.