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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Scientific Digital Imaging plc (LON:SDI) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Scientific Digital Imaging Carry?
You can click the graphic below for the historical numbers, but it shows that as of April 2019 Scientific Digital Imaging had UK£4.00m of debt, an increase on UK£1.42m, over one year. On the flip side, it has UK£2.49m in cash leading to net debt of about UK£1.51m.
A Look At Scientific Digital Imaging's Liabilities
According to the last reported balance sheet, Scientific Digital Imaging had liabilities of UK£4.00m due within 12 months, and liabilities of UK£5.46m due beyond 12 months. Offsetting this, it had UK£2.49m in cash and UK£3.34m in receivables that were due within 12 months. So its liabilities total UK£3.63m more than the combination of its cash and short-term receivables.
Of course, Scientific Digital Imaging has a market capitalization of UK£51.4m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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.
Scientific Digital Imaging's net debt is only 0.40 times its EBITDA. And its EBIT easily covers its interest expense, being 33.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Scientific Digital Imaging grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Scientific Digital Imaging'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Scientific Digital Imaging produced sturdy free cash flow equating to 77% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Scientific Digital Imaging'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! We would also note that Medical Equipment industry companies like Scientific Digital Imaging commonly do use debt without problems. It looks Scientific Digital Imaging has no trouble standing on its own two feet, and it has no reason to fear its lenders. To our minds it has a healthy happy balance sheet. Another factor that would give us confidence in Scientific Digital Imaging would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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.
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