We Think Smith-Midland (NASDAQ:SMID) Is Taking Some Risk With Its 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.' 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. Importantly, Smith-Midland Corporation (NASDAQ:SMID) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Smith-Midland

What Is Smith-Midland's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Smith-Midland had debt of US$6.57m, up from US$4.37m in one year. However, its balance sheet shows it holds US$10.8m in cash, so it actually has US$4.24m net cash.

How Healthy Is Smith-Midland's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Smith-Midland had liabilities of US$10.9m due within 12 months and liabilities of US$10.5m due beyond that. Offsetting these obligations, it had cash of US$10.8m as well as receivables valued at US$13.6m due within 12 months. So it actually has US$3.08m 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. Succinctly put, Smith-Midland boasts net cash, so it's fair to say it does not have a heavy debt load!

Shareholders should be aware that Smith-Midland's EBIT was down 90% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. Over the last three years, Smith-Midland reported free cash flow worth 12% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While it is always sensible to investigate a company's debt, in this case Smith-Midland has US$4.24m in net cash and a decent-looking balance sheet. So while Smith-Midland does not have a great balance sheet, it's certainly not too bad. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Smith-Midland (1 makes us a bit uncomfortable!) 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.

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.