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.' 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, Servotronics, Inc. (NYSEMKT:SVT) does carry debt. But the real question is whether this debt is making the company risky.
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Servotronics's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Servotronics had US$9.79m of debt, an increase on US$3.68m, over one year. However, it does have US$7.47m in cash offsetting this, leading to net debt of about US$2.32m.
A Look At Servotronics' Liabilities
According to the last reported balance sheet, Servotronics had liabilities of US$7.15m due within 12 months, and liabilities of US$11.7m due beyond 12 months. Offsetting this, it had US$7.47m in cash and US$6.77m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.63m.
While this might seem like a lot, it is not so bad since Servotronics has a market capitalization of US$20.6m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Servotronics's net debt is only 0.66 times its EBITDA. And its EBIT covers its interest expense a whopping 12.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Servotronics if management cannot prevent a repeat of the 42% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Servotronics'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Servotronics recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Servotronics's EBIT growth rate and conversion of EBIT to free cash flow 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. When we consider all the factors discussed, it seems to us that Servotronics is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Servotronics has 3 warning signs we think you should be aware of.
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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