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Sharps Compliance (NASDAQ:SMED) Seems To Use Debt Quite Sensibly

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Simply Wall St
·4 min read
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 can see that Sharps Compliance Corp. (NASDAQ:SMED) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sharps Compliance

What Is Sharps Compliance's Net Debt?

The chart below, which you can click on for greater detail, shows that Sharps Compliance had US$1.76m in debt in December 2019; about the same as the year before. However, its balance sheet shows it holds US$5.33m in cash, so it actually has US$3.57m net cash.

NasdaqCM:SMED Historical Debt April 21st 2020
NasdaqCM:SMED Historical Debt April 21st 2020

How Healthy Is Sharps Compliance's Balance Sheet?

According to the last reported balance sheet, Sharps Compliance had liabilities of US$11.2m due within 12 months, and liabilities of US$9.16m due beyond 12 months. On the other hand, it had cash of US$5.33m and US$12.4m worth of receivables due within a year. So it has liabilities totalling US$2.69m more than its cash and near-term receivables, combined.

Of course, Sharps Compliance has a market capitalization of US$119.6m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Sharps Compliance boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Sharps Compliance grew its EBIT by 698% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sharps Compliance'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Sharps Compliance may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Sharps Compliance burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Sharps Compliance has US$3.57m in net cash. And it impressed us with its EBIT growth of 698% over the last year. So we are not troubled with Sharps Compliance's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Sharps Compliance that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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.

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. Thank you for reading.