Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Smartpay Holdings Limited (NZSE:SPY) does use debt in its business. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Smartpay Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Smartpay Holdings had NZ$29.8m of debt, an increase on NZ$28.4m, over one year. However, because it has a cash reserve of NZ$8.19m, its net debt is less, at about NZ$21.6m.
How Healthy Is Smartpay Holdings' Balance Sheet?
According to the last reported balance sheet, Smartpay Holdings had liabilities of NZ$9.35m due within 12 months, and liabilities of NZ$29.3m due beyond 12 months. Offsetting this, it had NZ$8.19m in cash and NZ$2.03m in receivables that were due within 12 months. So its liabilities total NZ$28.4m more than the combination of its cash and short-term receivables.
Given Smartpay Holdings has a market capitalization of NZ$227.5m, 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Smartpay Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (5.6), and fairly weak interest coverage, since EBIT is just 0.015 times the interest expense. The debt burden here is substantial. However, the silver lining was that Smartpay Holdings achieved a positive EBIT of NZ$35k in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Smartpay 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 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, Smartpay Holdings actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We weren't impressed with Smartpay Holdings's net debt to EBITDA, and its interest cover made us cautious. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Smartpay Holdings's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Smartpay Holdings 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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