Warren Buffett famously said, '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 Socket Mobile, Inc. (NASDAQ:SCKT) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Socket Mobile's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Socket Mobile had US$2.41m of debt in June 2019, down from US$2.57m, one year before. On the flip side, it has US$1.02m in cash leading to net debt of about US$1.40m.
A Look At Socket Mobile's Liabilities
We can see from the most recent balance sheet that Socket Mobile had liabilities of US$5.43m falling due within a year, and liabilities of US$1.06m due beyond that. On the other hand, it had cash of US$1.02m and US$2.92m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.57m.
Since publicly traded Socket Mobile shares are worth a total of US$14.1m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
While we wouldn't worry about Socket Mobile's net debt to EBITDA ratio of 2.7, we think its super-low interest cover of 0.91 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even worse, Socket Mobile saw its EBIT tank 74% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Socket Mobile will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Socket Mobile recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While Socket Mobile's interest cover makes us cautious about it, its track record of (not) growing its EBIT is no better. But its not so bad at converting EBIT to free cash flow. Taking the abovementioned factors together we do think Socket Mobile's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. While Socket Mobile didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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