David Iben said it well when he said: “Volatility is not a risk that interests us. What matters to us is to avoid the permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We can see that Spartan Delta Corp. (TSE:SDE) uses debt in its business. But does this debt worry shareholders?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.
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What is Spartan Delta’s debt?
The image below, which you can click on for more details, shows that as of March 2022, Spartan Delta had C$356.6 million in debt, up from C$25.7 million in one year. Net debt is about the same, since she doesn’t have a lot of cash.
How strong is Spartan Delta’s balance sheet?
The latest balance sheet data shows that Spartan Delta had liabilities of C$307.7 million due within one year, and liabilities of C$553.4 million falling due thereafter. In return, he had C$1.55 million in cash and C$139.3 million in debt due within 12 months. It therefore has liabilities totaling C$720.2 million more than its cash and short-term receivables, combined.
Spartan Delta has a market capitalization of C$2.30 billion, so it could very likely raise funds to improve its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Spartan Delta has a low net debt to EBITDA ratio of just 0.81. And its EBIT easily covers its interest charges, which is 15.7 times the size. So we’re pretty relaxed about his super-conservative use of debt. Even better, Spartan Delta increased its EBIT by 1,521% last year, which is an impressive improvement. This boost will make it even easier to pay off debt in the future. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Spartan Delta can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past two years, Spartan Delta has burned a lot of cash. While investors no doubt expect a reversal of this situation in due course, this clearly means that its use of debt is more risky.
Our point of view
Spartan Delta’s EBIT to free cash flow conversion was a real negative in this analysis, even though the other factors we considered were considerably better. In particular, we are dazzled by its interest coverage. Given this range of data points, we believe Spartan Delta is in a good position to manage its level of leverage. But be warned: 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 reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 5 warning signs for Spartan Delta (1 of which is potentially serious!) that you should know about.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.