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.' 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 note that Vertu Motors plc (LON:VTU) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Vertu Motors

How Much Debt Does Vertu Motors Carry?

As you can see below, Vertu Motors had UK£56.5m of debt at August 2021, down from UK£66.5m a year prior. However, it does have UK£113.5m in cash offsetting this, leading to net cash of UK£57.0m. debt-equity-history-analysis

How Strong Is Vertu Motors' Balance Sheet?

We can see from the most recent balance sheet that Vertu Motors had liabilities of UK£515.9m falling due within a year, and liabilities of UK£156.6m due beyond that. Offsetting these obligations, it had cash of UK£113.5m as well as receivables valued at UK£43.0m due within 12 months. So its liabilities total UK£515.9m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the UK£226.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Vertu Motors would probably need a major re-capitalization if its creditors were to demand repayment. Vertu Motors boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.



Better yet, Vertu Motors grew its EBIT by 292% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Vertu Motors'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Vertu Motors 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 last three years, Vertu Motors actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although Vertu Motors's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£57.0m. And it impressed us with free cash flow of UK£59m, being 107% of its EBIT. So we don't have any problem with Vertu Motors's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified  2 warning signs for Vertu Motors (1 is significant)  you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.