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 note that Salem Media Group, Inc. (NASDAQ:SALM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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 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 Salem Media Group's Debt?
As you can see below, Salem Media Group had US$250.3m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Salem Media Group's Balance Sheet?
According to the last reported balance sheet, Salem Media Group had liabilities of US$66.2m due within 12 months, and liabilities of US$328.7m due beyond 12 months. On the other hand, it had cash of US$9.0k and US$35.2m worth of receivables due within a year. So its liabilities total US$359.6m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$41.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we definitely think shareholders need to watch this one closely. After all, Salem Media Group would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 7.0 hit our confidence in Salem Media Group like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Salem Media Group saw its EBIT tank 21% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Salem Media Group'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Salem Media Group produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, Salem Media Group's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Taking into account all the aforementioned factors, it looks like Salem Media Group has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around Salem Media Group's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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.