Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that Sims Metal Management Limited (ASX:SGM) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Sims Metal Management Carry?
The image below, which you can click on for greater detail, shows that Sims Metal Management had debt of AU$35.0m at the end of June 2019, a reduction from AU$41.0m over a year. But on the other hand it also has AU$397.0m in cash, leading to a AU$362.0m net cash position.
A Look At Sims Metal Management’s Liabilities
Zooming in on the latest balance sheet data, we can see that Sims Metal Management had liabilities of AU$658.7m due within 12 months and liabilities of AU$228.0m due beyond that. Offsetting this, it had AU$397.0m in cash and AU$356.3m in receivables that were due within 12 months. So it has liabilities totalling AU$133.4m more than its cash and near-term receivables, combined.
Of course, Sims Metal Management has a market capitalization of AU$2.05b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Sims Metal Management boasts net cash, so it’s fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Sims Metal Management if management cannot prevent a repeat of the 20% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sims Metal Management 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. While Sims Metal Management has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Sims Metal Management recorded free cash flow worth a fulsome 84% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
We could understand if investors are concerned about Sims Metal Management’s liabilities, but we can be reassured by the fact it has has net cash of AU$362.0m. The cherry on top was that in converted 84% of that EBIT to free cash flow, bringing in AU$163m. So we are not troubled with Sims Metal Management’s debt use. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Sims Metal Management insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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