Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Velan Inc. (TSE:VLN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, 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.
How Much Debt Does Velan Carry?
As you can see below, Velan had US$34.1m of debt at May 2022, down from US$74.0m a year prior. But it also has US$66.3m in cash to offset that, meaning it has US$32.2m net cash.
How Healthy Is Velan's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Velan had liabilities of US$154.9m due within 12 months and liabilities of US$83.0m due beyond that. On the other hand, it had cash of US$66.3m and US$102.1m worth of receivables due within a year. So its liabilities total US$69.5m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Velan has a market capitalization of US$125.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Velan boasts net cash, so it's fair to say it does not have a heavy debt load!
Although Velan made a loss at the EBIT level, last year, it was also good to see that it generated US$39m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Velan will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Velan 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. In the last year, Velan created free cash flow amounting to 17% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Although Velan's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$32.2m. So we are not troubled with Velan's debt use. We'd be motivated to research the stock further if we found out that Velan insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
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