L.S. Starrett (NYSE:SCX) Has A Pretty Healthy Balance Sheet

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, The L.S. Starrett Company (NYSE:SCX) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for L.S. Starrett

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

You can click the graphic below for the historical numbers, but it shows that L.S. Starrett had US$15.3m of debt in March 2023, down from US$32.2m, one year before. On the flip side, it has US$8.60m in cash leading to net debt of about US$6.66m.

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

According to the last reported balance sheet, L.S. Starrett had liabilities of US$37.6m due within 12 months, and liabilities of US$39.2m due beyond 12 months. Offsetting these obligations, it had cash of US$8.60m as well as receivables valued at US$36.3m due within 12 months. So its liabilities total US$31.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since L.S. Starrett has a market capitalization of US$78.3m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

L.S. Starrett has a low net debt to EBITDA ratio of only 0.24. And its EBIT easily covers its interest expense, being 22.4 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that L.S. Starrett saw its EBIT decline by 5.7% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is L.S. Starrett's earnings that will influence how the balance sheet holds up in the future. 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. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, L.S. Starrett reported free cash flow worth 17% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Both L.S. Starrett's ability to to cover its interest expense with its EBIT and its net debt to EBITDA gave us comfort that it can handle its debt. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about L.S. Starrett's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should be aware of the 1 warning sign we've spotted with L.S. Starrett .

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.