Does Smart Metering Systems (LON:SMS) Have A Healthy Balance Sheet?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Smart Metering Systems plc (LON:SMS) does carry debt. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.

View our latest analysis for Smart Metering Systems

How Much Debt Does Smart Metering Systems Carry?

The image below, which you can click on for greater detail, shows that at June 2021 Smart Metering Systems had debt of UK£31.8m, up from UK£12.8m in one year. However, it does have UK£37.3m in cash offsetting this, leading to net cash of UK£5.55m.

A Look At Smart Metering Systems' Liabilities

We can see from the most recent balance sheet that Smart Metering Systems had liabilities of UK£59.8m falling due within a year, and liabilities of UK£47.3m due beyond that. On the other hand, it had cash of UK£37.3m and UK£43.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£26.0m.

Of course, Smart Metering Systems has a market capitalization of UK£921.2m, 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. While it does have liabilities worth noting, Smart Metering Systems also has more cash than debt, so we're pretty confident it can manage its debt safely.

Importantly, Smart Metering Systems's EBIT fell a jaw-dropping 36% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Smart Metering Systems 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. Smart Metering Systems may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Smart Metering Systems burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

We could understand if investors are concerned about Smart Metering Systems's liabilities, but we can be reassured by the fact it has has net cash of UK£5.55m. So although we see some areas for improvement, we're not too worried about Smart Metering Systems's balance sheet. 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. To that end, you should learn about the 4 warning signs we've spotted with Smart Metering Systems (including 1 which makes us a bit uncomfortable) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

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