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 can see that SMCP S.A. (EPA:SMCP) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does SMCP Carry?
As you can see below, at the end of June 2019, SMCP had €349.6m of debt, up from €324.9m a year ago. Click the image for more detail. On the flip side, it has €49.7m in cash leading to net debt of about €299.9m.
How Strong Is SMCP’s Balance Sheet?
The latest balance sheet data shows that SMCP had liabilities of €311.6m due within a year, and liabilities of €859.5m falling due after that. Offsetting this, it had €49.7m in cash and €111.6m in receivables that were due within 12 months. So it has liabilities totalling €1.01b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €607.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, SMCP would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
SMCP has net debt worth 1.9 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 3.7 times the interest expense. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. We note that SMCP grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine SMCP’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, SMCP recorded free cash flow of 46% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
We’d go so far as to say SMCP’s level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making SMCP stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Be aware that SMCP is showing 1 warning sign in our investment analysis , you should know about…
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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