Here's Why Smith-Midland (NASDAQ:SMID) Can Manage Its Debt Responsibly

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.' 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. Importantly, Smith-Midland Corporation (NASDAQ:SMID) does carry debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Smith-Midland

How Much Debt Does Smith-Midland Carry?

The image below, which you can click on for greater detail, shows that Smith-Midland had debt of US$6.87m at the end of March 2022, a reduction from US$7.43m over a year. But it also has US$14.8m in cash to offset that, meaning it has US$7.95m net cash.

How Healthy Is Smith-Midland's Balance Sheet?

The latest balance sheet data shows that Smith-Midland had liabilities of US$14.6m due within a year, and liabilities of US$10.2m falling due after that. Offsetting this, it had US$14.8m in cash and US$12.9m in receivables that were due within 12 months. So it can boast US$2.93m more liquid assets than total liabilities.

This surplus suggests that Smith-Midland has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Smith-Midland boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Smith-Midland's saving grace is its low debt levels, because its EBIT has tanked 71% in the last twelve months. 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 you can't view debt in total isolation; since Smith-Midland will need earnings to service that debt. 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. Smith-Midland 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. Looking at the most recent three years, Smith-Midland recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Smith-Midland has US$7.95m in net cash and a decent-looking balance sheet. So we don't have any problem with Smith-Midland's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Smith-Midland (1 is a bit concerning!) that you should be aware of before investing here.

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.