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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.' 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. As with many other companies Pets at Home Group Plc (LON:PETS) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is at Home Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that at Home Group had UK£99.7m of debt in October 2021, down from UK£163.8m, one year before. But on the other hand it also has UK£164.7m in cash, leading to a UK£65.0m net cash position.
How Healthy Is at Home Group's Balance Sheet?
We can see from the most recent balance sheet that at Home Group had liabilities of UK£347.0m falling due within a year, and liabilities of UK£421.1m due beyond that. Offsetting this, it had UK£164.7m in cash and UK£50.1m in receivables that were due within 12 months. So its liabilities total UK£553.3m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because at Home Group is worth UK£2.09b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, at Home Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Another good sign is that at Home Group has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine at Home Group'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 company can only pay off debt with cold hard cash, not accounting profits. at Home Group 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 last three years, at Home Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While at Home Group does have more liabilities than liquid assets, it also has net cash of UK£65.0m. And it impressed us with free cash flow of UK£204m, being 147% of its EBIT. So is at Home Group's debt a risk? It doesn't seem so to us. 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. To that end, you should be aware of the 2 warning signs we've spotted with at Home Group .
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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