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.’ 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. As with many other companies Select Interior Concepts, Inc. (NASDAQ:SIC) makes use of debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. 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.
What Is Select Interior Concepts’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2020 Select Interior Concepts had US$201.3m of debt, an increase on US$185.4m, over one year. However, it does have US$36.9m in cash offsetting this, leading to net debt of about US$164.4m.
How Strong Is Select Interior Concepts’s Balance Sheet?
The latest balance sheet data shows that Select Interior Concepts had liabilities of US$78.7m due within a year, and liabilities of US$212.5m falling due after that. On the other hand, it had cash of US$36.9m and US$70.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$184.1m.
This deficit casts a shadow over the US$118.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Select Interior Concepts would probably need a major re-capitalization if its creditors were to demand repayment.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While we wouldn’t worry about Select Interior Concepts’s net debt to EBITDA ratio of 4.4, we think its super-low interest cover of 0.84 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Investors should also be troubled by the fact that Select Interior Concepts saw its EBIT drop by 13% over the last twelve months. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Select Interior Concepts’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. In the last three years, Select Interior Concepts’s free cash flow amounted to 42% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Select Interior Concepts’s level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. After considering the datapoints discussed, we think Select Interior Concepts has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. 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. For instance, we’ve identified 3 warning signs for Select Interior Concepts (1 is a bit unpleasant) 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.
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