Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, SpaceandPeople plc (LON:SAL) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is SpaceandPeople's Net Debt?
The chart below, which you can click on for greater detail, shows that SpaceandPeople had UK£1.78m in debt in December 2021; about the same as the year before. However, it also had UK£1.38m in cash, and so its net debt is UK£398.0k.
How Healthy Is SpaceandPeople's Balance Sheet?
The latest balance sheet data shows that SpaceandPeople had liabilities of UK£4.83m due within a year, and liabilities of UK£1.79m falling due after that. Offsetting this, it had UK£1.38m in cash and UK£1.92m in receivables that were due within 12 months. So its liabilities total UK£3.32m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of UK£2.59m, we think shareholders really should watch SpaceandPeople's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
SpaceandPeople has a very low debt to EBITDA ratio of 1.2 so it is strange to see weak interest coverage, with last year's EBIT being only 2.0 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. We also note that SpaceandPeople improved its EBIT from a last year's loss to a positive UK£153k. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SpaceandPeople's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, SpaceandPeople actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Neither SpaceandPeople's ability to cover its interest expense with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that SpaceandPeople is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for SpaceandPeople you should be aware of, and 1 of them is a bit unpleasant.
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.