Would Scott Technology (NZSE:SCT) Be Better Off With Less 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.' 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, Scott Technology Limited (NZSE:SCT) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Scott Technology

What Is Scott Technology's Debt?

You can click the graphic below for the historical numbers, but it shows that Scott Technology had NZ$11.2m of debt in August 2020, down from NZ$16.4m, one year before. However, because it has a cash reserve of NZ$8.78m, its net debt is less, at about NZ$2.41m.

How Strong Is Scott Technology's Balance Sheet?

We can see from the most recent balance sheet that Scott Technology had liabilities of NZ$80.9m falling due within a year, and liabilities of NZ$19.5m due beyond that. On the other hand, it had cash of NZ$8.78m and NZ$52.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$39.4m.

While this might seem like a lot, it is not so bad since Scott Technology has a market capitalization of NZ$183.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Carrying virtually no net debt, Scott Technology has a very light debt load indeed. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Scott Technology'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.

Over 12 months, Scott Technology made a loss at the EBIT level, and saw its revenue drop to NZ$190m, which is a fall of 16%. We would much prefer see growth.

Caveat Emptor

While Scott Technology's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at NZ$9.7m. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. Quite frankly we think the balance sheet is far from match-fit, although it could be improved with time. For example, we would not want to see a repeat of last year's loss of NZ$17m. So in short it's a really risky stock. 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. Take risks, for example - Scott Technology has 2 warning signs (and 1 which is significant) we think you should know about.

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.

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