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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that MaxiPARTS Limited (ASX:MXI) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is MaxiPARTS's Net Debt?
The image below, which you can click on for greater detail, shows that MaxiPARTS had debt of AU$17.3m at the end of June 2021, a reduction from AU$37.5m over a year. However, its balance sheet shows it holds AU$22.4m in cash, so it actually has AU$5.19m net cash.
How Healthy Is MaxiPARTS' Balance Sheet?
The latest balance sheet data shows that MaxiPARTS had liabilities of AU$126.9m due within a year, and liabilities of AU$31.8m falling due after that. Offsetting these obligations, it had cash of AU$22.4m as well as receivables valued at AU$33.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$103.1m.
This deficit is considerable relative to its market capitalization of AU$142.5m, so it does suggest shareholders should keep an eye on MaxiPARTS' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, MaxiPARTS also has more cash than debt, so we're pretty confident it can manage its debt safely.
Notably, MaxiPARTS's EBIT launched higher than Elon Musk, gaining a whopping 103% on last year. 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 MaxiPARTS 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. MaxiPARTS 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, MaxiPARTS 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.
Although MaxiPARTS's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$5.19m. And it impressed us with free cash flow of AU$25m, being 394% of its EBIT. So we don't have any problem with MaxiPARTS's use of debt. 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 1 warning sign we've spotted with MaxiPARTS .
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.
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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