Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that SigmaTron International, Inc. (NASDAQ:SGMA) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does SigmaTron International Carry?
The image below, which you can click on for greater detail, shows that at October 2020 SigmaTron International had debt of US$42.3m, up from US$36.3m in one year. However, it does have US$4.96m in cash offsetting this, leading to net debt of about US$37.3m.
A Look At SigmaTron International's Liabilities
The latest balance sheet data shows that SigmaTron International had liabilities of US$63.0m due within a year, and liabilities of US$44.8m falling due after that. On the other hand, it had cash of US$4.96m and US$31.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$71.5m.
This deficit casts a shadow over the US$25.2m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, SigmaTron International would likely require a major re-capitalisation if it had to pay its creditors today.
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.
SigmaTron International shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, SigmaTron International's EBIT was down 70% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is SigmaTron International'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, SigmaTron International produced sturdy free cash flow equating to 66% 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.
On the face of it, SigmaTron International's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like SigmaTron International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that SigmaTron International is showing 4 warning signs in our investment analysis , and 2 of those are a bit unpleasant...
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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What are the risks and opportunities for SigmaTron International?
Debt is not well covered by operating cash flow
High level of non-cash earnings
Does not have a meaningful market cap ($22M)
Shareholders have been diluted in the past year
Profit margins (0.04%) are lower than last year (4.1%)
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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