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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.' 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. As with many other companies Smith-Midland Corporation (NASDAQ:SMID) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Smith-Midland Carry?
As you can see below, Smith-Midland had US$7.21m of debt at June 2021, down from US$8.02m a year prior. However, its balance sheet shows it holds US$14.4m in cash, so it actually has US$7.23m net cash.
How Healthy Is Smith-Midland's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Smith-Midland had liabilities of US$14.0m due within 12 months and liabilities of US$11.2m due beyond that. Offsetting these obligations, it had cash of US$14.4m as well as receivables valued at US$12.5m due within 12 months. So it actually has US$1.66m more liquid assets than total liabilities.
This state of affairs indicates that Smith-Midland's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the US$91.5m company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Smith-Midland boasts net cash, so it's fair to say it does not have a heavy debt load!
Better yet, Smith-Midland grew its EBIT by 268% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Smith-Midland will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Smith-Midland 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. Over the last three years, Smith-Midland recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Smith-Midland has net cash of US$7.23m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$9.4m, being 88% of its EBIT. So is Smith-Midland's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Smith-Midland has 2 warning signs we think you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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