Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies The Mission Group plc (LON:TMG) uses debt. But should shareholders worry about its use of debt?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
Discover our latest analysis for Mission Group
What is Mission Group’s debt?
You can click on the chart below for historical figures, but it shows that in December 2021 Mission Group had a debt of £16.4m, up from £4.97m , over one year. However, he also had £6.07m in cash, so his net debt is £10.3m.
How strong is Mission Group’s balance sheet?
The latest balance sheet data shows Mission Group had liabilities of £38.4m due within a year, and liabilities of £27.6m falling due thereafter. In return, he had £6.07 million in cash and £38.4 million in debt due within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables of £21.5 million.
This shortfall is not that bad as Mission Group is worth £56.9m and could therefore probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Mission Group has a low net debt to EBITDA ratio of just 1.2. And its EBIT covers its interest charges 10.3 times more. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. What is even more impressive is that Mission Group increased its EBIT by 559% year-over-year. This boost will make paying off debt even easier in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Mission Group’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Mission Group has generated free cash flow of a very strong 99% of its EBIT, more than expected. This puts him in a very strong position to repay his debt.
Our point of view
The good news is that Mission Group’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, since its EBIT growth rate also confirms this impression! Overall, we think Mission Group’s use of debt seems entirely reasonable and we are not concerned about that. Although debt carries risks, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example – Mission Group has 3 warning signs we think you should know.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.