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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.' 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, Victrex plc (LON:VCT) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.
How Much Debt Does Victrex Carry?
As you can see below, at the end of March 2021, Victrex had UK£5.50m of debt, up from none a year ago. Click the image for more detail. But on the other hand it also has UK£79.6m in cash, leading to a UK£74.1m net cash position.
How Healthy Is Victrex's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Victrex had liabilities of UK£39.5m due within 12 months and liabilities of UK£34.9m due beyond that. On the other hand, it had cash of UK£79.6m and UK£45.6m worth of receivables due within a year. So it actually has UK£50.8m more liquid assets than total liabilities.
This short term liquidity is a sign that Victrex could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Victrex boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Victrex's saving grace is its low debt levels, because its EBIT has tanked 36% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Victrex's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Victrex 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, Victrex recorded free cash flow worth 67% 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 we empathize with investors who find debt concerning, you should keep in mind that Victrex has net cash of UK£74.1m, as well as more liquid assets than liabilities. The cherry on top was that in converted 67% of that EBIT to free cash flow, bringing in UK£60m. So we don't have any problem with Victrex's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Victrex is showing 1 warning sign in our investment analysis , you should know about...
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.
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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