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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.' 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 Science Group plc (LON:SAG) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. 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. 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 Science Group Carry?
You can click the graphic below for the historical numbers, but it shows that Science Group had UK£16.2m of debt in June 2021, down from UK£17.8m, one year before. But on the other hand it also has UK£29.0m in cash, leading to a UK£12.8m net cash position.
How Healthy Is Science Group's Balance Sheet?
We can see from the most recent balance sheet that Science Group had liabilities of UK£29.4m falling due within a year, and liabilities of UK£18.8m due beyond that. Offsetting this, it had UK£29.0m in cash and UK£13.7m in receivables that were due within 12 months. So its liabilities total UK£5.63m more than the combination of its cash and short-term receivables.
Of course, Science Group has a market capitalization of UK£183.5m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Science Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although Science Group made a loss at the EBIT level, last year, it was also good to see that it generated UK£6.7m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Science Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Science Group has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Science Group actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We could understand if investors are concerned about Science Group's liabilities, but we can be reassured by the fact it has has net cash of UK£12.8m. The cherry on top was that in converted 187% of that EBIT to free cash flow, bringing in UK£13m. So is Science Group's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Science Group is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...
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. 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.
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