Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Victrex AG (LON:VCT) uses debt in its business. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth, without any negative consequences. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
Check out our latest analysis for Victrex
What is Victrex’s debt?
As you can see below, at the end of March 2022, Victrex had a debt of £15.6m, up from £5.50m a year ago. Click on the image for more details. However, his balance sheet shows he is holding £45.8m in cash, so he actually has a net cash of £30.2m.
A Look at Victrex’s Responsibilities
We can see from the most recent balance sheet that Victrex had liabilities of £57.6m due within a year, and liabilities of £59.9m due beyond. On the other hand, it had cash of £45.8 million and £68.6 million of receivables due within the year. Thus, its liabilities total £3.10 million more than the combination of its cash and short-term receivables.
This state of affairs indicates that Victrex’s balance sheet looks quite strong, as its total liabilities roughly equal its liquid assets. So while it’s hard to imagine the £1.43billion UK company struggling for cash, we still think it’s worth keeping an eye on its balance sheet. While it has liabilities to note, Victrex also has more cash than debt, so we’re pretty confident it can manage its debt safely.
Another good sign, Victrex was able to increase its EBIT by 25% in twelve months, thus facilitating the repayment of its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Victrex can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. Although Victrex has net cash on its balance sheet, it’s always worth looking at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how fast it’s building (or erodes) this cash balance. . Over the past three years, Victrex has recorded free cash flow of 64% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
We can understand that investors are concerned about Victrex’s liabilities, but we can take comfort in the fact that it has a net cash position of £30.2m. And we liked the look of EBIT growth of 25% YoY last year. So is Victrex’s debt a risk? This does not seem to us to be the case. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we have identified 2 warning signs for Victrex of which you should be aware.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.