We Think Psychemedics (NASDAQ:PMD) Can Stay On Top Of Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Psychemedics Corporation (NASDAQ:PMD) 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 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. 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. 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 Psychemedics

What Is Psychemedics's Debt?

As you can see below, at the end of March 2020, Psychemedics had US$2.46m of debt, up from US$1.53m a year ago. Click the image for more detail. However, its balance sheet shows it holds US$5.33m in cash, so it actually has US$2.87m net cash.

How Strong Is Psychemedics's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Psychemedics had liabilities of US$4.91m due within 12 months and liabilities of US$4.49m due beyond that. On the other hand, it had cash of US$5.33m and US$3.56m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$513.0k.

Having regard to Psychemedics's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the US$28.3m company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Psychemedics boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Psychemedics if management cannot prevent a repeat of the 61% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is Psychemedics's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Psychemedics 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. During the last three years, Psychemedics produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

We could understand if investors are concerned about Psychemedics's liabilities, but we can be reassured by the fact it has has net cash of US$2.87m. And it impressed us with free cash flow of US$1.5m, being 71% of its EBIT. So we don't have any problem with Psychemedics's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Psychemedics 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.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.