Warren Buffett said: “Volatility is far from synonymous with risk”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that Somi Conveyor Beltings Limited (NSE: SOMICONVEY) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, debt can be an important tool in businesses, especially capital intensive businesses. When we look at debt levels, we first look at cash and debt levels, together.
Check out our latest analysis for Somi conveyor belts
How much debt do Somi conveyor belts carry?
As you can see below, Somi Conveyor Beltings was owed 239.6 million yen in September 2021, which is roughly the same as the year before. You can click on the graph for more details. However, he also had 90.3 million yen in cash, so his net debt is 149.2 million yen.
How healthy is Somi Conveyor Beltings’ record?
Zooming in on the latest balance sheet data, we can see that Somi Conveyor Beltings had a liability of 350.2 million yen owed within 12 months and a liability of 47.3 million yen owed beyond. In compensation for these obligations, he had cash of 90.3 million as well as receivables valued at 216.3 million maturing within 12 months. Thus, its liabilities exceed the sum of its cash and its receivables (short term) by 90.9 million.
Of course, Somi Conveyor Beltings has a market cap of 515.9 million yen, so this liability is probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.
Even though Somi Conveyor Beltings’ debt is only 2.1%, its interest coverage is really very low at 2.5. This suggests that the company is paying fairly high interest rates. Either way, it’s safe to say that the business has significant debt. We have seen Somi Conveyor Beltings increase its EBIT by 3.0% over the past twelve months. It’s far from incredible, but it’s a good thing when it comes to paying down debt. When analyzing debt levels, the balance sheet is the obvious place to start. But you can’t look at debt in isolation; since Somi Conveyor Beltings will need income to repay this debt. So, when considering debt, it is really worth looking at the profit trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Somi Conveyor Beltings has generated strong free cash flow equivalent to 67% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Somi Conveyor Beltings’ interest coverage was really negative in this analysis, although the other factors we considered were considerably better. In particular, we are dazzled by its conversion of EBIT into free cash flow. When we consider all the elements mentioned above, it seems to us that Somi Conveyor Beltings manages its debt quite well. But beware: we believe debt levels are high enough to warrant continued monitoring. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example, Somi Conveyor Beltings has 3 warning signs (and 1 which is of concern) we think you should be aware of.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.