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. As with many other companies Verastem, Inc. (NASDAQ:VSTM) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Verastem
What Is Verastem’s Debt?
You can click the graphic below for the historical numbers, but it shows that Verastem had US$56.5m of debt in September 2020, down from US$136.1m, one year before. However, it does have US$170.5m in cash offsetting this, leading to net cash of US$113.9m.
How Healthy Is Verastem’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Verastem had liabilities of US$37.7m due within 12 months and liabilities of US$50.3m due beyond that. Offsetting this, it had US$170.5m in cash and US$5.69m in receivables that were due within 12 months. So it can boast US$88.2m more liquid assets than total liabilities.
This surplus liquidity suggests that Verastem’s balance sheet could take a hit just as well as Homer Simpson’s head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Verastem has more cash than debt is arguably a good indication that it can manage its debt safely. 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 Verastem’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.
In the last year Verastem wasn’t profitable at an EBIT level, but managed to grow its revenue by 508%, to US$92m. When it comes to revenue growth, that’s like nailing the game winning 3-pointer!
So How Risky Is Verastem?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that Verastem had an earnings before interest and tax (EBIT) loss, over the last year. Indeed, in that time it burnt through US$49m of cash and made a loss of US$87m. However, it has net cash of US$113.9m, so it has a bit of time before it will need more capital. The good news for shareholders is that Verastem has dazzling revenue growth, so there’s a very good chance it can boost its free cash flow in the years to come. High growth pre-profit companies may well be risky, but they can also offer great rewards. 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. Case in point: We’ve spotted 1 warning sign for Verastem you should be aware of.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
This article by Simply Wall St is general in nature. 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.
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