Is Sensient Technologies (NYSE:SXT) A Risky Investment?

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, Sensient Technologies Corporation (NYSE:SXT) does carry debt. But the more important question is: how much risk is that debt creating?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Sensient Technologies

What Is Sensient Technologies's Debt?

As you can see below, at the end of September 2023, Sensient Technologies had US$671.4m of debt, up from US$569.1m a year ago. Click the image for more detail. However, it also had US$32.0m in cash, and so its net debt is US$639.4m.

How Healthy Is Sensient Technologies' Balance Sheet?

We can see from the most recent balance sheet that Sensient Technologies had liabilities of US$223.8m falling due within a year, and liabilities of US$728.7m due beyond that. On the other hand, it had cash of US$32.0m and US$284.7m worth of receivables due within a year. So it has liabilities totalling US$635.9m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Sensient Technologies is worth US$2.46b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Sensient Technologies has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.1 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Sadly, Sensient Technologies's EBIT actually dropped 3.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sensient Technologies can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Sensient Technologies recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Sensient Technologies's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But it seems to be able to cover its interest expense with its EBIT without much trouble. We think that Sensient Technologies's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 2 warning signs for Sensient Technologies (1 is concerning!) 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.

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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.