Is Sharps Compliance (NASDAQ:SMED) 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.' 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 Sharps Compliance Corp. (NASDAQ:SMED) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

Check out our latest analysis for Sharps Compliance

What Is Sharps Compliance's Debt?

As you can see below, Sharps Compliance had US$3.86m of debt at September 2021, down from US$5.52m a year prior. But on the other hand it also has US$41.2m in cash, leading to a US$37.3m net cash position.

A Look At Sharps Compliance's Liabilities

According to the last reported balance sheet, Sharps Compliance had liabilities of US$15.7m due within 12 months, and liabilities of US$11.2m due beyond 12 months. Offsetting these obligations, it had cash of US$41.2m as well as receivables valued at US$9.87m due within 12 months. So it can boast US$24.1m more liquid assets than total liabilities.

This surplus suggests that Sharps Compliance is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Sharps Compliance boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Sharps Compliance made a loss at the EBIT level, last year, it was also good to see that it generated US$12m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sharps Compliance can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Sharps Compliance has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Sharps Compliance actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sharps Compliance has net cash of US$37.3m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$15m, being 130% of its EBIT. So we don't think Sharps Compliance's use of debt is risky. 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. For example Sharps Compliance has 3 warning signs (and 1 which is a bit concerning) we think you should know about.

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.