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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. 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 Engenco Limited (ASX:EGN) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. 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.
See our latest analysis for Engenco
How Much Debt Does Engenco Carry?
You can click the graphic below for the historical numbers, but it shows that Engenco had AU$294.0k of debt in June 2019, down from AU$338.0k, one year before. But it also has AU$23.7m in cash to offset that, meaning it has AU$23.4m net cash.
How Strong Is Engenco's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Engenco had liabilities of AU$26.8m due within 12 months and liabilities of AU$1.07m due beyond that. On the other hand, it had cash of AU$23.7m and AU$30.3m worth of receivables due within a year. So it can boast AU$26.2m more liquid assets than total liabilities.
This excess liquidity suggests that Engenco is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Engenco boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Engenco's EBIT dived 16%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Engenco 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Engenco 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 most recent three years, Engenco recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.