Does SThree (LON:STEM) 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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies SThree plc (LON:STEM) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 SThree

What Is SThree's Debt?

The image below, which you can click on for greater detail, shows that SThree had debt of UK£4.54m at the end of November 2019, a reduction from UK£54.9m over a year. But it also has UK£15.1m in cash to offset that, meaning it has UK£10.6m net cash.

How Healthy Is SThree's Balance Sheet?

According to the last reported balance sheet, SThree had liabilities of UK£186.9m due within 12 months, and liabilities of UK£1.40m due beyond 12 months. On the other hand, it had cash of UK£15.1m and UK£262.8m worth of receivables due within a year. So it actually has UK£89.6m more liquid assets than total liabilities.

This surplus strongly suggests that SThree has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, SThree boasts net cash, so it's fair to say it does not have a heavy debt load!

Also good is that SThree grew its EBIT at 11% over the last year, further increasing its ability to manage 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 SThree'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 company can only pay off debt with cold hard cash, not accounting profits. While SThree has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, SThree recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that SThree has net cash of UK£10.6m, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 11% in the last twelve months. So is SThree's debt a risk? It doesn't seem so to us. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with SThree (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

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