Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Scales Corporation Limited (NZSE:SCL) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for Scales
How Much Debt Does Scales Carry?
As you can see below, Scales had NZ$53.9m of debt at June 2021, down from NZ$58.7m a year prior. But it also has NZ$91.2m in cash to offset that, meaning it has NZ$37.3m net cash.
A Look At Scales' Liabilities
Zooming in on the latest balance sheet data, we can see that Scales had liabilities of NZ$104.6m due within 12 months and liabilities of NZ$141.3m due beyond that. On the other hand, it had cash of NZ$91.2m and NZ$77.0m worth of receivables due within a year. So it has liabilities totalling NZ$77.6m more than its cash and near-term receivables, combined.
Of course, Scales has a market capitalization of NZ$719.7m, 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, Scales also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also good is that Scales grew its EBIT at 19% over the last year, further increasing its ability to manage debt. 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Scales 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 most recent three years, Scales recorded free cash flow worth 56% 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 Scales does have more liabilities than liquid assets, it also has net cash of NZ$37.3m. And we liked the look of last year's 19% year-on-year EBIT growth. So is Scales's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Scales has 2 warning signs we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.