Spirax-Sarco Engineering (LON:SPX) Has A Pretty Healthy Balance Sheet

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.' 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 can see that Spirax-Sarco Engineering plc (LON:SPX) does use debt in its business. But the real question is whether this debt is making the company risky.

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Net Debt?

As you can see below, at the end of June 2023, Spirax-Sarco Engineering had UK£1.07b of debt, up from UK£507.6m a year ago. Click the image for more detail. On the flip side, it has UK£322.8m in cash leading to net debt of about UK£748.3m.

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

According to the last reported balance sheet, Spirax-Sarco Engineering had liabilities of UK£585.7m due within 12 months, and liabilities of UK£976.7m due beyond 12 months. Offsetting this, it had UK£322.8m in cash and UK£328.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£910.7m.

Of course, Spirax-Sarco Engineering has a market capitalization of UK£7.30b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Spirax-Sarco Engineering's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its commanding EBIT of 14.2 times its interest expense, implies the debt load is as light as a peacock feather. Importantly Spirax-Sarco Engineering's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. 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 Spirax-Sarco Engineering'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Spirax-Sarco Engineering produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Spirax-Sarco Engineering's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And its conversion of EBIT to free cash flow is good too. All these things considered, it appears that Spirax-Sarco Engineering can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Spirax-Sarco Engineering you should know about.

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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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.