Schaffer (ASX:SFC) Seems To Use Debt Quite Sensibly

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 note that Schaffer Corporation Limited (ASX:SFC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Schaffer

What Is Schaffer's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Schaffer had debt of AU$54.0m, up from AU$29.7m in one year. On the flip side, it has AU$35.2m in cash leading to net debt of about AU$18.8m.

How Strong Is Schaffer's Balance Sheet?

We can see from the most recent balance sheet that Schaffer had liabilities of AU$40.3m falling due within a year, and liabilities of AU$79.1m due beyond that. Offsetting these obligations, it had cash of AU$35.2m as well as receivables valued at AU$20.1m due within 12 months. So it has liabilities totalling AU$64.1m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Schaffer has a market capitalization of AU$245.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). 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).

Schaffer has a low net debt to EBITDA ratio of only 0.54. And its EBIT easily covers its interest expense, being 12.0 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In fact Schaffer's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is Schaffer'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.

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. During the last three years, Schaffer produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen Schaffer is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the elements mentioned above, it seems to us that Schaffer is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Schaffer that you should be aware of before investing here.

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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