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Is Flexible Solutions International (NYSEMKT:FSI) A Risky Investment?

Simply Wall St

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Flexible Solutions International Inc. (NYSEMKT:FSI) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Flexible Solutions International

How Much Debt Does Flexible Solutions International Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2019 Flexible Solutions International had US$7.37m of debt, an increase on US$501.5k, over one year. However, because it has a cash reserve of US$5.37m, its net debt is less, at about US$2.00m.

AMEX:FSI Historical Debt, September 4th 2019

How Healthy Is Flexible Solutions International's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Flexible Solutions International had liabilities of US$6.54m due within 12 months and liabilities of US$5.61m due beyond that. On the other hand, it had cash of US$5.37m and US$3.35m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.43m.

Since publicly traded Flexible Solutions International shares are worth a total of US$30.3m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

While Flexible Solutions International's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.8 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Flexible Solutions International grew its EBIT by 7.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Flexible Solutions International can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Flexible Solutions International recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Flexible Solutions International's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better In particular, we thought its EBIT growth rate was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Flexible Solutions International's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Flexible Solutions International's dividend history, without delay!

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.