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 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. Importantly, SPAR Group, Inc. (NASDAQ:SGRP) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does SPAR Group Carry?
As you can see below, SPAR Group had US$19.3m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$7.83m in cash leading to net debt of about US$11.5m.
How Strong Is SPAR Group’s Balance Sheet?
According to the last reported balance sheet, SPAR Group had liabilities of US$52.4m due within 12 months, and liabilities of US$5.56m due beyond 12 months. Offsetting this, it had US$7.83m in cash and US$57.5m in receivables that were due within 12 months. So it can boast US$7.29m more liquid assets than total liabilities.
This excess liquidity is a great indication that SPAR Group’s balance sheet is just as strong as racists are weak. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
SPAR Group’s net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 10.6 times the size. So we’re pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that SPAR Group grew its EBIT by 139% over twelve months. That boost will make it even easier to pay down debt going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is SPAR Group’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. So we always check how much of that EBIT is translated into free cash flow. In the last three years, SPAR Group’s free cash flow amounted to 22% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
The good news is that SPAR Group’s demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Zooming out, SPAR Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We’d be very excited to see if SPAR Group insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.