Is Saras (BIT:SRS) Using Too Much Debt?

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 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 Saras S.p.A. (BIT:SRS) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Saras

What Is Saras's Debt?

The image below, which you can click on for greater detail, shows that Saras had debt of €505.2m at the end of June 2023, a reduction from €741.3m over a year. However, it also had €499.4m in cash, and so its net debt is €5.89m.

How Healthy Is Saras' Balance Sheet?

We can see from the most recent balance sheet that Saras had liabilities of €1.86b falling due within a year, and liabilities of €671.3m due beyond that. Offsetting these obligations, it had cash of €499.4m as well as receivables valued at €512.0m due within 12 months. So it has liabilities totalling €1.52b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of €1.37b, we think shareholders really should watch Saras'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. Saras may have virtually no net debt, but it does have a lot of liabilities.

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).

With debt at a measly 0.0078 times EBITDA and EBIT covering interest a whopping 16.8 times, it's clear that Saras is not a desperate borrower. So relative to past earnings, the debt load seems trivial. On the other hand, Saras's EBIT dived 14%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Saras can strengthen its balance sheet over time. 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 two years, Saras produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We feel some trepidation about Saras's difficulty EBIT growth rate, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Saras 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Saras you should be aware of, and 1 of them is concerning.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.