Is L.S. Starrett (NYSE:SCX) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 The L.S. Starrett Company (NYSE:SCX) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for L.S. Starrett

What Is L.S. Starrett's Net Debt?

The chart below, which you can click on for greater detail, shows that L.S. Starrett had US$27.5m in debt in September 2021; about the same as the year before. However, because it has a cash reserve of US$6.63m, its net debt is less, at about US$20.9m.

How Healthy Is L.S. Starrett's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that L.S. Starrett had liabilities of US$56.3m due within 12 months and liabilities of US$50.1m due beyond that. Offsetting these obligations, it had cash of US$6.63m as well as receivables valued at US$39.1m due within 12 months. So it has liabilities totalling US$60.6m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$74.7m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

L.S. Starrett's net debt is only 0.84 times its EBITDA. And its EBIT covers its interest expense a whopping 28.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Although L.S. Starrett made a loss at the EBIT level, last year, it was also good to see that it generated US$19m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is L.S. Starrett's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, L.S. Starrett burned a lot of cash. 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

L.S. Starrett's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think L.S. Starrett's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that L.S. Starrett is showing 5 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.