David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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, Smith-Midland Corporation (NASDAQ:SMID) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Smith-Midland's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Smith-Midland had US$7.78m of debt, an increase on US$4.50m, over one year. But it also has US$8.66m in cash to offset that, meaning it has US$877.0k net cash.
A Look At Smith-Midland's Liabilities
We can see from the most recent balance sheet that Smith-Midland had liabilities of US$9.47m falling due within a year, and liabilities of US$13.7m due beyond that. Offsetting this, it had US$8.66m in cash and US$10.6m in receivables that were due within 12 months. So it has liabilities totalling US$3.92m more than its cash and near-term receivables, combined.
Of course, Smith-Midland has a market capitalization of US$67.3m, 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. While it does have liabilities worth noting, Smith-Midland also has more cash than debt, so we're pretty confident it can manage its debt safely.
Another good sign is that Smith-Midland has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is Smith-Midland's earnings that will influence how the balance sheet holds up in the future. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Smith-Midland has US$877.0k in net cash. The cherry on top was that in converted 97% of that EBIT to free cash flow, bringing in US$3.3m. So we don't think Smith-Midland's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Smith-Midland , and understanding them should be part of your investment process.
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.
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. 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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