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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 essensys plc (LON:ESYS) does use debt in its business. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 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 essensys
What Is essensys's Net Debt?
The image below, which you can click on for greater detail, shows that at January 2019 essensys had debt of UK£9.75m, up from UK£8.92m in one year. However, it does have UK£4.57m in cash offsetting this, leading to net debt of about UK£5.19m.
How Healthy Is essensys's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that essensys had liabilities of UK£6.83m due within 12 months and liabilities of UK£10.2m due beyond that. On the other hand, it had cash of UK£4.57m and UK£8.09m worth of receivables due within a year. So it has liabilities totalling UK£4.35m more than its cash and near-term receivables, combined.
Given essensys has a market capitalization of UK£79.4m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 1.5 times and a disturbingly high net debt to EBITDA ratio of 6.2 hit our confidence in essensys like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for essensys is that it turned last year's EBIT loss into a gain of UK£534k, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine essensys's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.