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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that The L.S. Starrett Company (NYSE:SCX) 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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is L.S. Starrett’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that L.S. Starrett had US$21.0m of debt in March 2019, down from US$22.4m, one year before. However, it also had US$12.9m in cash, and so its net debt is US$8.18m.
How Strong Is L.S. Starrett’s Balance Sheet?
According to the last reported balance sheet, L.S. Starrett had liabilities of US$27.9m due within 12 months, and liabilities of US$64.9m due beyond 12 months. On the other hand, it had cash of US$12.9m and US$32.6m worth of receivables due within a year. So its liabilities total US$47.4m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company’s US$40.6m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
L.S. Starrett’s net debt is only 0.50 times its EBITDA. And its EBIT easily covers its interest expense, being 12.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that L.S. Starrett grew its EBIT by 154% over twelve months. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is L.S. Starrett’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, L.S. Starrett burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While L.S. Starrett’s conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think L.S. Starrett’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if L.S. Starrett insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
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