Is Spirit Technology Solutions (ASX:ST1) A Risky Investment?

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 Spirit Technology Solutions Ltd (ASX:ST1) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Spirit Technology Solutions

How Much Debt Does Spirit Technology Solutions Carry?

The image below, which you can click on for greater detail, shows that at December 2021 Spirit Technology Solutions had debt of AU$25.0m, up from AU$5.27m in one year. However, it also had AU$10.4m in cash, and so its net debt is AU$14.6m.

A Look At Spirit Technology Solutions' Liabilities

We can see from the most recent balance sheet that Spirit Technology Solutions had liabilities of AU$59.9m falling due within a year, and liabilities of AU$12.8m due beyond that. On the other hand, it had cash of AU$10.4m and AU$17.6m worth of receivables due within a year. So its liabilities total AU$44.7m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Spirit Technology Solutions is worth AU$98.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Even though Spirit Technology Solutions's debt is only 1.8, its interest cover is really very low at 1.5. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. We also note that Spirit Technology Solutions improved its EBIT from a last year's loss to a positive AU$1.4m. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Spirit Technology Solutions'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Spirit Technology Solutions burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Spirit Technology Solutions's interest cover left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability handle its debt, based on its EBITDA, isn't such a worry. Overall, we think it's fair to say that Spirit Technology Solutions has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 instance, we've identified 3 warning signs for Spirit Technology Solutions that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.