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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies EML Payments Limited (ASX:EML) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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, 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.

See our latest analysis for EML Payments

What Is EML Payments's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 EML Payments had AU$35.8m of debt, an increase on AU$15.0m, over one year. However, it does have AU$951.8m in cash offsetting this, leading to net cash of AU$915.9m.

A Look At EML Payments's Liabilities

We can see from the most recent balance sheet that EML Payments had liabilities of AU$1.33b falling due within a year, and liabilities of AU$139.0m due beyond that. On the other hand, it had cash of AU$951.8m and AU$44.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$469.5m.

EML Payments has a market capitalization of AU$1.10b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, EML Payments boasts net cash, so it's fair to say it does not have a heavy debt load!

Shareholders should be aware that EML Payments's EBIT was down 55% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if EML Payments 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While EML Payments 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. Over the last three years, EML Payments 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.

Summing up

Although EML Payments'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$915.9m. And it impressed us with free cash flow of AU$11m, being 136% of its EBIT. So although we see some areas for improvement, we're not too worried about EML Payments's balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with EML Payments .

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. 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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