Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Sdiptech AB (publ) (STO:SDIP B) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Sdiptech's Debt?
As you can see below, at the end of June 2019, Sdiptech had kr1.10b of debt, up from kr853.7m a year ago. Click the image for more detail. However, because it has a cash reserve of kr224.3m, its net debt is less, at about kr873.8m.
A Look At Sdiptech's Liabilities
We can see from the most recent balance sheet that Sdiptech had liabilities of kr405.0m falling due within a year, and liabilities of kr1.17b due beyond that. Offsetting these obligations, it had cash of kr224.3m as well as receivables valued at kr417.0m due within 12 months. So its liabilities total kr935.7m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of kr1.45b, so it does suggest shareholders should keep an eye on Sdiptech's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
With net debt to EBITDA of 3.3 Sdiptech has a fairly noticeable amount of debt. But the high interest coverage of 8.6 suggests it can easily service that debt. We note that Sdiptech grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sdiptech's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sdiptech produced sturdy free cash flow equating to 54% 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.
Both Sdiptech's ability to to grow its EBIT and its interest cover gave us comfort that it can handle its debt. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. Considering this range of data points, we think Sdiptech is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Sdiptech insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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