Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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 Stoneridge, Inc. (NYSE:SRI) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Stoneridge Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Stoneridge had US$111.8m of debt, an increase on US$104.0m, over one year. However, it does have US$55.3m in cash offsetting this, leading to net debt of about US$56.5m.
How Strong Is Stoneridge’s Balance Sheet?
The latest balance sheet data shows that Stoneridge had liabilities of US$160.6m due within a year, and liabilities of US$156.8m falling due after that. On the other hand, it had cash of US$55.3m and US$143.6m worth of receivables due within a year. So its liabilities total US$118.5m more than the combination of its cash and short-term receivables.
Since publicly traded Stoneridge shares are worth a total of US$840.7m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Stoneridge has a low net debt to EBITDA ratio of only 0.61. And its EBIT easily covers its interest expense, being 15.1 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Stoneridge’s EBIT dived 12%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Stoneridge’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Stoneridge produced sturdy free cash flow equating to 55% 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 Stoneridge’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 Stoneridge is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Stoneridge insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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