Does SIFCO Industries (NYSEMKT:SIF) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, SIFCO Industries, Inc. (NYSEMKT:SIF) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for SIFCO Industries

What Is SIFCO Industries's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 SIFCO Industries had US$24.6m of debt, an increase on US$23.4m, over one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is SIFCO Industries's Balance Sheet?

According to the last reported balance sheet, SIFCO Industries had liabilities of US$43.3m due within 12 months, and liabilities of US$33.1m due beyond 12 months. Offsetting this, it had US$427.0k in cash and US$36.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$39.1m.

When you consider that this deficiency exceeds the company's US$31.4m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

SIFCO Industries's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.0 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. Notably, SIFCO Industries made a loss at the EBIT level, last year, but improved that to positive EBIT of US$4.4m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is SIFCO Industries'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, SIFCO Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

We'd go so far as to say SIFCO Industries's conversion of EBIT to free cash flow was disappointing. But at least its interest cover is not so bad. Overall, it seems to us that SIFCO Industries's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that SIFCO Industries is showing 5 warning signs in our investment analysis , and 2 of those are a bit concerning...

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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