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. 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. We can see that Medlab Clinical Limited (ASX:MDC) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Medlab Clinical's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Medlab Clinical had debt of AU$972.0k, up from AU$499.7k in one year. However, it does have AU$11.4m in cash offsetting this, leading to net cash of AU$10.5m.
How Strong Is Medlab Clinical's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Medlab Clinical had liabilities of AU$4.98m due within 12 months and liabilities of AU$228.2k due beyond that. Offsetting these obligations, it had cash of AU$11.4m as well as receivables valued at AU$3.81m due within 12 months. So it actually has AU$10.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Medlab Clinical could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Medlab Clinical has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Medlab Clinical 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.
In the last year Medlab Clinical wasn't profitable at an EBIT level, but managed to grow its revenue by31%, to AU$5.4m. Shareholders probably have their fingers crossed that it can grow its way to profits.
So How Risky Is Medlab Clinical?
Statistically speaking companies that lose money are riskier than those that make money. And in the last year Medlab Clinical had negative earnings before interest and tax (EBIT), truth be told. Indeed, in that time it burnt through AU$11m of cash and made a loss of AU$8.1m. However, it has net cash of AU$10.5m, so it has a bit of time before it will need more capital. Medlab Clinical's revenue growth shone bright over the last year, so it may well be in a position to turn a profit in due course. By investing before those profits, shareholders take on more risk in the hope of bigger rewards. For riskier companies like Medlab Clinical I always like to keep an eye on whether insiders are buying or selling. So click here if you want to find out for yourself.
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.
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