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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Spirax-Sarco Engineering plc (LON:SPX) does use debt in its business. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Spirax-Sarco Engineering Carry?
The chart below, which you can click on for greater detail, shows that Spirax-Sarco Engineering had UK£557.7m in debt in June 2019; about the same as the year before. On the flip side, it has UK£166.2m in cash leading to net debt of about UK£391.5m.
How Healthy Is Spirax-Sarco Engineering's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Spirax-Sarco Engineering had liabilities of UK£298.9m due within 12 months and liabilities of UK£677.9m due beyond that. Offsetting this, it had UK£166.2m in cash and UK£260.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£550.2m.
Since publicly traded Spirax-Sarco Engineering shares are worth a total of UK£5.80b, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Spirax-Sarco Engineering has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 39.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Spirax-Sarco Engineering grew its EBIT by 29% 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 Spirax-Sarco Engineering'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Spirax-Sarco Engineering produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, Spirax-Sarco Engineering's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Spirax-Sarco Engineering's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Spirax-Sarco Engineering, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.