Does Spirax-Sarco Engineering (LON:SPX) Have A Healthy Balance Sheet?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Spirax-Sarco Engineering plc (LON:SPX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Spirax-Sarco Engineering

What Is Spirax-Sarco Engineering's Debt?

The chart below, which you can click on for greater detail, shows that Spirax-Sarco Engineering had UK£1.03b in debt in December 2023; about the same as the year before. On the flip side, it has UK£359.7m in cash leading to net debt of about UK£666.7m.

How Healthy Is Spirax-Sarco Engineering's Balance Sheet?

According to the last reported balance sheet, Spirax-Sarco Engineering had liabilities of UK£454.0m due within 12 months, and liabilities of UK£1.10b due beyond 12 months. Offsetting these obligations, it had cash of UK£359.7m as well as receivables valued at UK£308.5m due within 12 months. So its liabilities total UK£882.5m more than the combination of its cash and short-term receivables.

Given Spirax-Sarco Engineering has a market capitalization of UK£7.43b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Spirax-Sarco Engineering's net debt of 1.7 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.2 times its interest expenses harmonizes with that theme. The bad news is that Spirax-Sarco Engineering saw its EBIT decline by 13% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Spirax-Sarco Engineering'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Spirax-Sarco Engineering recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Based on what we've seen Spirax-Sarco Engineering 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 thought its interest cover was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Spirax-Sarco Engineering's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Spirax-Sarco Engineering , and understanding them should be part of your investment process.

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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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.