Is Smith-Midland (NASDAQ:SMID) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Smith-Midland Corporation (NASDAQ:SMID) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Smith-Midland

What Is Smith-Midland's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Smith-Midland had US$7.21m of debt in June 2021, down from US$8.02m, one year before. However, its balance sheet shows it holds US$14.4m in cash, so it actually has US$7.23m net cash.

How Healthy Is Smith-Midland's Balance Sheet?

The latest balance sheet data shows that Smith-Midland had liabilities of US$14.0m due within a year, and liabilities of US$11.2m falling due after that. On the other hand, it had cash of US$14.4m and US$12.5m worth of receivables due within a year. So it can boast US$1.66m more liquid assets than total liabilities.

This state of affairs indicates that Smith-Midland's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$96.9m company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Smith-Midland boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Smith-Midland grew its EBIT by 268% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept 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. During the last three years, Smith-Midland generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Smith-Midland has US$7.23m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 88% of that EBIT to free cash flow, bringing in US$9.4m. So is Smith-Midland's debt a risk? It doesn't seem so to us. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Smith-Midland 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.
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