The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Socket Mobile, Inc. (NASDAQ:SCKT) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Socket Mobile's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Socket Mobile had US$2.09m of debt in September 2021, down from US$2.49m, one year before. However, it does have US$5.35m in cash offsetting this, leading to net cash of US$3.27m.
How Healthy Is Socket Mobile's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Socket Mobile had liabilities of US$5.08m due within 12 months and liabilities of US$267.7k due beyond that. On the other hand, it had cash of US$5.35m and US$2.70m worth of receivables due within a year. So it actually has US$2.71m more liquid assets than total liabilities.
This surplus suggests that Socket Mobile has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Socket Mobile has more cash than debt is arguably a good indication that it can manage its debt safely.
Although Socket Mobile made a loss at the EBIT level, last year, it was also good to see that it generated US$2.5m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Socket Mobile's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Socket Mobile has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent year, Socket Mobile recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that Socket Mobile has net cash of US$3.27m, as well as more liquid assets than liabilities. So we don't have any problem with Socket Mobile's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 5 warning signs with Socket Mobile (at least 2 which are potentially serious) , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.