Is Scales (NZSE:SCL) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Scales Corporation Limited (NZSE:SCL) makes use of debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Scales

How Much Debt Does Scales Carry?

As you can see below, Scales had NZ$39.4m of debt at June 2022, down from NZ$53.9m a year prior. But on the other hand it also has NZ$56.4m in cash, leading to a NZ$17.0m net cash position.

A Look At Scales' Liabilities

We can see from the most recent balance sheet that Scales had liabilities of NZ$133.5m falling due within a year, and liabilities of NZ$142.3m due beyond that. Offsetting these obligations, it had cash of NZ$56.4m as well as receivables valued at NZ$101.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$117.8m.

Of course, Scales has a market capitalization of NZ$622.3m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Scales boasts net cash, so it's fair to say it does not have a heavy debt load!

And we also note warmly that Scales grew its EBIT by 15% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Scales can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Scales has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Scales produced sturdy free cash flow equating to 62% 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.

Summing Up

Although Scales's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of NZ$17.0m. And we liked the look of last year's 15% year-on-year EBIT growth. So we don't think Scales's use of debt is risky. 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. We've identified 1 warning sign with Scales , and understanding them should be part of your investment process.

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. 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.