The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Speedy Hire Plc (LON:SDY) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Speedy Hire's Debt?
As you can see below, Speedy Hire had UK£77.4m of debt at September 2020, down from UK£90.9m a year prior. On the flip side, it has UK£18.9m in cash leading to net debt of about UK£58.5m.
A Look At Speedy Hire's Liabilities
The latest balance sheet data shows that Speedy Hire had liabilities of UK£109.2m due within a year, and liabilities of UK£134.5m falling due after that. On the other hand, it had cash of UK£18.9m and UK£95.8m worth of receivables due within a year. So it has liabilities totalling UK£129.0m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Speedy Hire is worth UK£340.3m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
While Speedy Hire's low debt to EBITDA ratio of 0.78 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.1 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The bad news is that Speedy Hire saw its EBIT decline by 16% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. 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 Speedy Hire's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. Happily for any shareholders, Speedy Hire actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
When it comes to the balance sheet, the standout positive for Speedy Hire was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. In particular, EBIT growth rate gives us cold feet. Looking at all this data makes us feel a little cautious about Speedy Hire's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Speedy Hire that you should be aware of.
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.
If you’re looking to trade Speedy Hire, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
This article by Simply Wall St is general in nature. 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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.