Smith-Midland (NASDAQ:SMID) Could Easily Take On More Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Smith-Midland Corporation (NASDAQ:SMID) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Smith-Midland

What Is Smith-Midland's Net Debt?

As you can see below, at the end of September 2020, Smith-Midland had US$7.78m of debt, up from US$4.50m a year ago. Click the image for more detail. However, its balance sheet shows it holds US$8.66m in cash, so it actually has US$877.0k net cash.

A Look At Smith-Midland's Liabilities

According to the last reported balance sheet, Smith-Midland had liabilities of US$9.47m due within 12 months, and liabilities of US$13.7m due beyond 12 months. Offsetting these obligations, it had cash of US$8.66m as well as receivables valued at US$10.6m due within 12 months. So it has liabilities totalling US$3.92m more than its cash and near-term receivables, combined.

Of course, Smith-Midland has a market capitalization of US$57.8m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Smith-Midland also has more cash than debt, so we're pretty confident it can manage its debt safely.

Another good sign is that Smith-Midland has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Over the last three years, Smith-Midland recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

We could understand if investors are concerned about Smith-Midland's liabilities, but we can be reassured by the fact it has has net cash of US$877.0k. And it impressed us with free cash flow of US$3.3m, being 97% of its EBIT. 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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Smith-Midland you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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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