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

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Smith-Midland Corporation (NASDAQ:SMID) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Smith-Midland

How Much Debt Does Smith-Midland Carry?

As you can see below, Smith-Midland had US$6.72m of debt at June 2022, down from US$7.21m a year prior. However, its balance sheet shows it holds US$12.4m in cash, so it actually has US$5.71m net cash.

How Strong Is Smith-Midland's Balance Sheet?

We can see from the most recent balance sheet that Smith-Midland had liabilities of US$11.5m falling due within a year, and liabilities of US$10.7m due beyond that. On the other hand, it had cash of US$12.4m and US$13.5m worth of receivables due within a year. So it actually has US$3.67m more liquid assets than total liabilities.

This short term liquidity is a sign that Smith-Midland could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Smith-Midland has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Smith-Midland if management cannot prevent a repeat of the 76% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Smith-Midland's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Smith-Midland 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. Looking at the most recent three years, Smith-Midland recorded free cash flow of 26% 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$5.71m 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. To that end, you should be aware of the 1 warning sign we've spotted with Smith-Midland .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.