Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Like many other companies Purple Innovation, Inc. (NASDAQ: PRPL) uses debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first look at cash and debt levels, together.
What is Purple Innovation’s net debt?
The graph below, which you can click for more details, shows Purple Innovation owed US $ 44.0 million in debt as of September 2021; about the same as the year before. But on the other hand, it also has $ 83.6 million in cash, which leads to a net cash position of $ 39.6 million.
NasdaqGS: PRPL History of debt to equity November 26, 2021
How healthy is Purple Innovation’s track record?
Zooming in on the latest balance sheet data, we can see that Purple Innovation had a liability of US $ 133.4 million due within 12 months and a liability of US $ 299.7 million beyond. In compensation for these obligations, he had cash of US $ 83.6 million as well as receivables valued at US $ 27.6 million due within 12 months. It therefore has a liability totaling US $ 321.9 million more than its cash and short-term receivables combined.
While that might sound like a lot, it’s not so bad since Purple Innovation has a market cap of US $ 772.4 million, and could therefore likely strengthen its balance sheet by raising capital if needed. But we absolutely want to keep our eyes open for indications that its debt is too risky. Despite its notable liabilities, Purple Innovation has a net cash flow, so it’s fair to say that it doesn’t have a heavy debt load!
Fortunately, Purple Innovation’s load is not too heavy, as its EBIT has fallen by 77% compared to last year. When a business sees its profits accumulate, it can sometimes see its relationship with its lenders deteriorate. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Purple Innovation can strengthen its balance sheet over time. So, if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business can only repay its debts with hard cash, not with book profits. While Purple Innovation has net cash on its balance sheet, it’s still worth looking at its ability to convert earnings before interest and taxes (EBIT) into free cash flow, to help us understand how fast it’s building ( or erodes) this cash balance. Over the past three years, Purple Innovation has created a free cash flow of 19% of its EBIT, a performance without interest. For us, the conversion to cash that elicits a bit of paranoia is the ability to extinguish debt.
While Purple Innovation’s balance sheet is not particularly strong, due to total liabilities it is clearly positive to see that it has net cash of US $ 39.6 million. So while we see areas for improvement, we are not too worried about Purple Innovation’s record. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 2 warning signs for Purple Innovation you must be aware.
At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.
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