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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Ecofibre Limited (ASX:EOF) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Ecofibre
How Much Debt Does Ecofibre Carry?
You can click the graphic below for the historical numbers, but it shows that Ecofibre had AU$1.34m of debt in June 2019, down from AU$6.07m, one year before. But it also has AU$25.7m in cash to offset that, meaning it has AU$24.4m net cash.
A Look At Ecofibre's Liabilities
The latest balance sheet data shows that Ecofibre had liabilities of AU$5.08m due within a year, and liabilities of AU$392.0k falling due after that. Offsetting this, it had AU$25.7m in cash and AU$3.11m in receivables that were due within 12 months. So it actually has AU$23.4m more liquid assets than total liabilities.
This surplus suggests that Ecofibre has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Ecofibre boasts net cash, so it's fair to say it does not have a heavy debt load!
Although Ecofibre made a loss at the EBIT level, last year, it was also good to see that it generated AU$3.1m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ecofibre's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. While Ecofibre 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. During the last year, Ecofibre burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.