Scales (NZSE:SCL) Has A Pretty Healthy Balance Sheet
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.' 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. As with many other companies Scales Corporation Limited (NZSE:SCL) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for Scales
What Is Scales's Debt?
The image below, which you can click on for greater detail, shows that at December 2018 Scales had debt of NZ$73.1m, up from NZ$47.7m in one year. However, it does have NZ$2.79m in cash offsetting this, leading to net debt of about NZ$70.3m.
How Healthy Is Scales's Balance Sheet?
We can see from the most recent balance sheet that Scales had liabilities of NZ$73.4m falling due within a year, and liabilities of NZ$87.8m due beyond that. Offsetting these obligations, it had cash of NZ$2.79m as well as receivables valued at NZ$22.9m due within 12 months. So its liabilities total NZ$135.5m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Scales has a market capitalization of NZ$644.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Scales has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 18.2 times the size. So we're pretty relaxed about its super-conservative use of debt. And we also note warmly that Scales grew its EBIT by 13% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Scales can strengthen its balance sheet over time. 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Scales's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Scales's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And its EBIT growth rate is good too. Looking at all the aforementioned factors together, it strikes us that Scales can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Scales's dividend history, without delay!
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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. Thank you for reading.