Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Standard Motor Products, Inc. (NYSE:SMP) makes use of debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Standard Motor Products’s Net Debt?
The image below, which you can click on for greater detail, shows that Standard Motor Products had debt of US$91.2m at the end of June 2020, a reduction from US$135.2m over a year. However, because it has a cash reserve of US$22.5m, its net debt is less, at about US$68.7m.
A Look At Standard Motor Products’s Liabilities
Zooming in on the latest balance sheet data, we can see that Standard Motor Products had liabilities of US$337.6m due within 12 months and liabilities of US$96.5m due beyond that. On the other hand, it had cash of US$22.5m and US$184.5m worth of receivables due within a year. So it has liabilities totalling US$227.1m more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Standard Motor Products is worth US$1.02b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Standard Motor Products has a low net debt to EBITDA ratio of only 0.68. And its EBIT easily covers its interest expense, being 18.7 times the size. So we’re pretty relaxed about its super-conservative use of debt. But the bad news is that Standard Motor Products has seen its EBIT plunge 17% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Standard Motor Products’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.
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. During the last three years, Standard Motor Products produced sturdy free cash flow equating to 58% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis Standard Motor Products’s interest cover should signal that it won’t have too much trouble with its debt. But the other factors we noted above weren’t so encouraging. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. Considering this range of data points, we think Standard Motor Products is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 1 warning sign for Standard Motor Products 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.
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