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 Standard Motor Products, Inc. (NYSE:SMP) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Standard Motor Products's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Standard Motor Products had US$127.1m of debt, an increase on US$93.7m, over one year. On the flip side, it has US$17.4m in cash leading to net debt of about US$109.7m.
How Healthy Is Standard Motor Products's Balance Sheet?
According to the last reported balance sheet, Standard Motor Products had liabilities of US$393.9m due within 12 months, and liabilities of US$90.3m due beyond 12 months. Offsetting these obligations, it had cash of US$17.4m as well as receivables valued at US$179.4m due within 12 months. So it has liabilities totalling US$287.5m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Standard Motor Products has a market capitalization of US$1.05b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Standard Motor Products has a low net debt to EBITDA ratio of only 0.79. And its EBIT covers its interest expense a whopping 23.4 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Standard Motor Products has increased its EBIT by 6.0% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Standard Motor Products's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Standard Motor Products recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On our analysis Standard Motor Products's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. Considering this range of data points, we think Standard Motor Products 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. We'd be motivated to research the stock further if we found out that Standard Motor Products insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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