David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Scales Corporation Limited (NZSE:SCL) makes use of debt. But the real question is whether this debt is making the company risky.
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 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Scales Carry?
As you can see below, Scales had NZ$55.6m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have NZ$152.1m in cash offsetting this, leading to net cash of NZ$96.4m.
How Strong Is Scales' Balance Sheet?
According to the last reported balance sheet, Scales had liabilities of NZ$56.7m due within 12 months, and liabilities of NZ$151.1m due beyond 12 months. Offsetting these obligations, it had cash of NZ$152.1m as well as receivables valued at NZ$19.5m due within 12 months. So it has liabilities totalling NZ$36.3m more than its cash and near-term receivables, combined.
Of course, Scales has a market capitalization of NZ$605.3m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Scales also has more cash than debt, so we're pretty confident it can manage its debt safely.
The good news is that Scales has increased its EBIT by 2.3% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Scales's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Scales may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Scales recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
We could understand if investors are concerned about Scales's liabilities, but we can be reassured by the fact it has has net cash of NZ$96.4m. And it impressed us with free cash flow of NZ$29m, being 73% of its EBIT. So we don't think Scales's use of debt is risky. 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. For instance, we've identified 2 warning signs for Scales that you should be aware of.
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. 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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