Is Skellerup Holdings (NZSE:SKL) Using Too Much Debt?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Skellerup Holdings Limited (NZSE:SKL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 Skellerup Holdings

What Is Skellerup Holdings's Debt?

The image below, which you can click on for greater detail, shows that Skellerup Holdings had debt of NZ$42.4m at the end of June 2020, a reduction from NZ$46.4m over a year. However, it does have NZ$13.6m in cash offsetting this, leading to net debt of about NZ$28.8m.

A Look At Skellerup Holdings's Liabilities

Zooming in on the latest balance sheet data, we can see that Skellerup Holdings had liabilities of NZ$36.6m due within 12 months and liabilities of NZ$62.5m due beyond that. Offsetting these obligations, it had cash of NZ$13.6m as well as receivables valued at NZ$46.5m due within 12 months. So it has liabilities totalling NZ$39.0m more than its cash and near-term receivables, combined.

Given Skellerup Holdings has a market capitalization of NZ$638.6m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Skellerup Holdings has a low net debt to EBITDA ratio of only 0.61. And its EBIT easily covers its interest expense, being 18.9 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Skellerup Holdings saw its EBIT decline by 3.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Skellerup Holdings 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Skellerup Holdings produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Skellerup Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its EBIT growth rate. Zooming out, Skellerup Holdings seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Skellerup Holdings is showing 2 warning signs in our investment analysis , 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.

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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.
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