David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Ocean Bio-Chem, Inc. (NASDAQ:OBCI) does use debt in its business. 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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Ocean Bio-Chem’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Ocean Bio-Chem had US$3.86m of debt in June 2021, down from US$4.37m, one year before. But it also has US$8.30m in cash to offset that, meaning it has US$4.44m net cash.
How Strong Is Ocean Bio-Chem’s Balance Sheet?
The latest balance sheet data shows that Ocean Bio-Chem had liabilities of US$6.44m due within a year, and liabilities of US$3.99m falling due after that. Offsetting these obligations, it had cash of US$8.30m as well as receivables valued at US$13.6m due within 12 months. So it actually has US$11.4m more liquid assets than total liabilities.
This surplus suggests that Ocean Bio-Chem has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Ocean Bio-Chem has more cash than debt is arguably a good indication that it can manage its debt safely.
In addition to that, we’re happy to report that Ocean Bio-Chem has boosted its EBIT by 74%, thus reducing the spectre of future debt repayments. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Ocean Bio-Chem will need earnings to service that debt.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Ocean Bio-Chem 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 three years, Ocean Bio-Chem 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.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Ocean Bio-Chem has net cash of US$4.44m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 74% over the last year. So we don’t think Ocean Bio-Chem’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start.