Scott Technology (NZSE:SCT) Has A Pretty 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.' 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. We note that Scott Technology Limited (NZSE:SCT) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Scott Technology

What Is Scott Technology's Net Debt?

As you can see below, Scott Technology had NZ$9.15m of debt at February 2021, down from NZ$20.2m a year prior. However, it also had NZ$6.20m in cash, and so its net debt is NZ$2.95m.

A Look At Scott Technology's Liabilities

According to the last reported balance sheet, Scott Technology had liabilities of NZ$66.9m due within 12 months, and liabilities of NZ$16.3m due beyond 12 months. Offsetting these obligations, it had cash of NZ$6.20m as well as receivables valued at NZ$46.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$30.4m.

Given Scott Technology has a market capitalization of NZ$195.8m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 0.57 times EBITDA, it is initially surprising to see that Scott Technology's EBIT has low interest coverage of 0.28 times. So one way or the other, it's clear the debt levels are not trivial. We also note that Scott Technology improved its EBIT from a last year's loss to a positive NZ$431k. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Scott Technology will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Scott Technology actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Scott Technology's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that Scott Technology can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Scott Technology (of which 1 is potentially serious!) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

If you’re looking to trade a wide range of investments, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

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