We Think Mayville Engineering Company (NYSE:MEC) Is Taking Some Risk With Its Debt

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.' 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 note that Mayville Engineering Company, Inc. (NYSE:MEC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Mayville Engineering Company

What Is Mayville Engineering Company's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Mayville Engineering Company had debt of US$83.3m, up from US$46.5m in one year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Mayville Engineering Company's Balance Sheet?

According to the last reported balance sheet, Mayville Engineering Company had liabilities of US$88.8m due within 12 months, and liabilities of US$151.6m due beyond 12 months. On the other hand, it had cash of US$120.0k and US$77.6m worth of receivables due within a year. So it has liabilities totalling US$162.6m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$180.5m, so it does suggest shareholders should keep an eye on Mayville Engineering Company's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Mayville Engineering Company's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 4.5 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. We also note that Mayville Engineering Company improved its EBIT from a last year's loss to a positive US$9.1m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Mayville Engineering Company 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. Over the last year, Mayville Engineering Company saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Mulling over Mayville Engineering Company's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. We're quite clear that we consider Mayville Engineering Company to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 1 warning sign for Mayville Engineering Company that you should be aware of before investing here.

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. 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.