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. 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 note that Isentia Group Limited (ASX:ISD) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Isentia Group
What Is Isentia Group's Net Debt?
The image below, which you can click on for greater detail, shows that Isentia Group had debt of AU$43.3m at the end of June 2019, a reduction from AU$55.8m over a year. However, because it has a cash reserve of AU$14.7m, its net debt is less, at about AU$28.5m.
How Healthy Is Isentia Group's Balance Sheet?
The latest balance sheet data shows that Isentia Group had liabilities of AU$35.1m due within a year, and liabilities of AU$48.4m falling due after that. Offsetting these obligations, it had cash of AU$14.7m as well as receivables valued at AU$20.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$48.7m.
While this might seem like a lot, it is not so bad since Isentia Group has a market capitalization of AU$85.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.