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 seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies SPX FLOW, Inc. (NYSE:FLOW) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is SPX FLOW’s Debt?
You can click the graphic below for the historical numbers, but it shows that SPX FLOW had US$756.3m of debt in March 2019, down from US$863.3m, one year before. However, because it has a cash reserve of US$202.2m, its net debt is less, at about US$554.1m.
A Look At SPX FLOW’s Liabilities
Zooming in on the latest balance sheet data, we can see that SPX FLOW had liabilities of US$656.8m due within 12 months and liabilities of US$986.9m due beyond that. On the other hand, it had cash of US$202.2m and US$446.5m worth of receivables due within a year. So its liabilities total US$995.0m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since SPX FLOW has a market capitalization of US$1.73b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
SPX FLOW has net debt worth 2.2 times EBITDA, which isn’t too much, but its interest cover looks a bit on the low side, with EBIT at only 4.4 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 SPX FLOW 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 ultimately the future profitability of the business will decide if SPX FLOW can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, SPX FLOW produced sturdy free cash flow equating to 59% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
When it comes to the balance sheet, the standout positive for SPX FLOW was the fact that it seems able to grow its EBIT confidently. However, our other observations weren’t so heartening. For example, its level of total liabilities makes us a little nervous about its debt. Considering this range of data points, we think SPX FLOW 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. Over time, share prices tend to follow earnings per share, so if you’re interested in SPX FLOW, you may well want to click here to check an interactive graph of its earnings per share history.
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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