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.' 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. Importantly, Stepan Company (NYSE:SCL) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Stepan Carry?
You can click the graphic below for the historical numbers, but it shows that Stepan had US$192.3m of debt in June 2019, down from US$286.8m, one year before. But it also has US$275.3m in cash to offset that, meaning it has US$83.0m net cash.
How Healthy Is Stepan's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Stepan had liabilities of US$299.5m due within 12 months and liabilities of US$371.1m due beyond that. On the other hand, it had cash of US$275.3m and US$289.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$106.3m.
Given Stepan has a market capitalization of US$2.25b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Stepan boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Stepan's EBIT dived 12%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Stepan'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Stepan has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Stepan recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Stepan has US$83m in net cash. The cherry on top was that in converted 69% of that EBIT to free cash flow, bringing in US$90m. So we don't have any problem with Stepan's use of debt. We'd be motivated to research the stock further if we found out that Stepan insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
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