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. We note that Satcom Systems Ltd (TLV:STCM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Satcom Systems's Debt?
As you can see below, Satcom Systems had US$11.3m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of US$3.24m, its net debt is less, at about US$8.06m.
How Healthy Is Satcom Systems' Balance Sheet?
We can see from the most recent balance sheet that Satcom Systems had liabilities of US$36.3m falling due within a year, and liabilities of US$15.6m due beyond that. Offsetting this, it had US$3.24m in cash and US$11.7m in receivables that were due within 12 months. So its liabilities total US$36.9m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$12.3m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Satcom Systems would likely require a major re-capitalisation if it had to pay its creditors today.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Given net debt is only 1.3 times EBITDA, it is initially surprising to see that Satcom Systems's EBIT has low interest coverage of 1.2 times. So one way or the other, it's clear the debt levels are not trivial. Notably, Satcom Systems's EBIT launched higher than Elon Musk, gaining a whopping 3,666% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Satcom Systems's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Satcom Systems actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We feel some trepidation about Satcom Systems's difficulty level of total liabilities, but we've got positives to focus on, too. To wit both its conversion of EBIT to free cash flow and EBIT growth rate were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Satcom Systems is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that Satcom Systems is showing 5 warning signs in our investment analysis , and 2 of those are concerning...
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.
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