Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that S&W Seed Company (NASDAQ:SANW) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is S&W Seed's Net Debt?
You can click the graphic below for the historical numbers, but it shows that S&W Seed had US$21.8m of debt in June 2019, down from US$46.1m, one year before. On the flip side, it has US$3.43m in cash leading to net debt of about US$18.3m.
A Look At S&W Seed's Liabilities
According to the last reported balance sheet, S&W Seed had liabilities of US$33.9m due within 12 months, and liabilities of US$12.4m due beyond 12 months. Offsetting these obligations, it had cash of US$3.43m as well as receivables valued at US$13.4m due within 12 months. So it has liabilities totalling US$29.6m more than its cash and near-term receivables, combined.
S&W Seed has a market capitalization of US$80.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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.
Looking at its net debt to EBITDA of 1.0 and interest cover of 4.3 times, it seems to us that S&W Seed is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We also note that S&W Seed improved its EBIT from a last year's loss to a positive US$14m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if S&W Seed 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, S&W Seed actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Happily, S&W Seed's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its interest cover does undermine this impression a bit. All these things considered, it appears that S&W Seed can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Even though S&W Seed lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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