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.' 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. We can see that Standard Motor Products, Inc. (NYSE:SMP) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Standard Motor Products Carry?
The image below, which you can click on for greater detail, shows that Standard Motor Products had debt of US$10.2m at the end of December 2020, a reduction from US$57.0m over a year. However, its balance sheet shows it holds US$19.5m in cash, so it actually has US$9.26m net cash.
How Healthy Is Standard Motor Products' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Standard Motor Products had liabilities of US$302.6m due within 12 months and liabilities of US$103.7m due beyond that. Offsetting this, it had US$19.5m in cash and US$198.0m in receivables that were due within 12 months. So it has liabilities totalling US$188.8m more than its cash and near-term receivables, combined.
Of course, Standard Motor Products has a market capitalization of US$951.8m, 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. Despite its noteworthy liabilities, Standard Motor Products boasts net cash, so it's fair to say it does not have a heavy debt load!
Also good is that Standard Motor Products grew its EBIT at 15% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Standard Motor Products'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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Standard Motor Products 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. During the last three years, Standard Motor Products produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Although Standard Motor Products's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$9.26m. So is Standard Motor Products's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Standard Motor Products (of which 1 is a bit concerning!) 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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