Smith-Midland (NASDAQ:SMID) Could Easily Take On More 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. 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 and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Smith-Midland

What Is Smith-Midland's Debt?

You can click the graphic below for the historical numbers, but it shows that Smith-Midland had US$4.37m of debt in September 2021, down from US$7.78m, one year before. However, it does have US$16.2m in cash offsetting this, leading to net cash of US$11.9m.

How Strong Is Smith-Midland's Balance Sheet?

The latest balance sheet data shows that Smith-Midland had liabilities of US$13.0m due within a year, and liabilities of US$10.8m falling due after that. Offsetting these obligations, it had cash of US$16.2m as well as receivables valued at US$13.1m due within 12 months. So it actually has US$5.50m 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. Simply put, the fact that Smith-Midland has more cash than debt is arguably a good indication that it can manage its debt safely.

Better yet, Smith-Midland grew its EBIT by 112% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. 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.

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. During the last three years, Smith-Midland produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Smith-Midland has US$11.9m in net cash and a decent-looking balance sheet. And we liked the look of last year's 112% year-on-year EBIT growth. 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. For instance, we've identified 2 warning signs for Smith-Midland that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.