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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 Simpson Manufacturing Co., Inc. (NYSE:SSD) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Simpson Manufacturing’s Net Debt?
The image below, which you can click on for greater detail, shows that Simpson Manufacturing had debt of US$2.42m at the end of March 2019, a reduction from US$3.49m over a year. But it also has US$113.4m in cash to offset that, meaning it has US$111.0m net cash.
A Look At Simpson Manufacturing’s Liabilities
Zooming in on the latest balance sheet data, we can see that Simpson Manufacturing had liabilities of US$150.6m due within 12 months and liabilities of US$44.3m due beyond that. On the other hand, it had cash of US$113.4m and US$173.1m worth of receivables due within a year. So it can boast US$91.7m more liquid assets than total liabilities.
This short term liquidity is a sign that Simpson Manufacturing could probably pay off its debt with ease, as its balance sheet is far from stretched. Simpson Manufacturing boasts net cash, so it’s fair to say it does not have a heavy debt load!
Also good is that Simpson Manufacturing grew its EBIT at 14% over the last year, further increasing its ability to manage debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Simpson Manufacturing 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Simpson Manufacturing 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, Simpson Manufacturing produced sturdy free cash flow equating to 59% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Simpson Manufacturing has net cash of US$111m, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 14% in the last twelve months. So we don’t think Simpson Manufacturing’s use of debt is risky. We’d be motivated to research the stock further if we found out that Simpson Manufacturing insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.