Is Seco/Warwick (WSE:SWG) Using Too Much 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.' 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 note that Seco/Warwick S.A. (WSE:SWG) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Seco/Warwick

What Is Seco/Warwick's Debt?

As you can see below, Seco/Warwick had zł26.8m of debt at September 2020, down from zł67.7m a year prior. But on the other hand it also has zł44.7m in cash, leading to a zł17.9m net cash position.

A Look At Seco/Warwick's Liabilities

According to the last reported balance sheet, Seco/Warwick had liabilities of zł201.2m due within 12 months, and liabilities of zł49.8m due beyond 12 months. Offsetting these obligations, it had cash of zł44.7m as well as receivables valued at zł167.6m due within 12 months. So its liabilities total zł38.8m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Seco/Warwick is worth zł116.9m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Seco/Warwick boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Seco/Warwick's saving grace is its low debt levels, because its EBIT has tanked 36% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Seco/Warwick will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Seco/Warwick 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. Over the last three years, Seco/Warwick recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

While Seco/Warwick does have more liabilities than liquid assets, it also has net cash of zł17.9m. The cherry on top was that in converted 91% of that EBIT to free cash flow, bringing in zł60m. So we are not troubled with Seco/Warwick's debt use. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Seco/Warwick , and understanding them should be part of your investment process.

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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