Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Spirax-Sarco Engineering plc (LON:SPX) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, 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.
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What Is Spirax-Sarco Engineering’s Debt?
As you can see below, at the end of June 2022, Spirax-Sarco Engineering had UK£507.6m of debt, up from UK£446.4m a year ago. Click the image for more detail. On the flip side, it has UK£304.9m in cash leading to net debt of about UK£202.7m.
How Healthy Is Spirax-Sarco Engineering’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Spirax-Sarco Engineering had liabilities of UK£361.7m due within 12 months and liabilities of UK£612.7m due beyond that. On the other hand, it had cash of UK£304.9m and UK£320.5m worth of receivables due within a year. So it has liabilities totalling UK£349.0m more than its cash and near-term receivables, combined.
Of course, Spirax-Sarco Engineering has a titanic market capitalization of UK£8.74b, 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Spirax-Sarco Engineering’s net debt is only 0.52 times its EBITDA. And its EBIT easily covers its interest expense, being 59.8 times the size. So we’re pretty relaxed about its super-conservative use of debt. Also positive, Spirax-Sarco Engineering grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 Spirax-Sarco Engineering can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Spirax-Sarco Engineering produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
Spirax-Sarco Engineering’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 that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, Spirax-Sarco Engineering seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. We’d be very excited to see if Spirax-Sarco Engineering insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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.