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, Select Interior Concepts, Inc. (NASDAQ:SIC) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Select Interior Concepts Carry?
As you can see below, Select Interior Concepts had US$157.1m of debt at March 2021, down from US$201.3m a year prior. However, it also had US$4.11m in cash, and so its net debt is US$153.0m.
How Strong Is Select Interior Concepts’ Balance Sheet?
The latest balance sheet data shows that Select Interior Concepts had liabilities of US$99.2m due within a year, and liabilities of US$151.4m falling due after that. Offsetting this, it had US$4.11m in cash and US$83.8m in receivables that were due within 12 months. So it has liabilities totalling US$162.7m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of US$247.7m, so it does suggest shareholders should keep an eye on Select Interior Concepts’ use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Select Interior Concepts shareholders face the double whammy of a high net debt to EBITDA ratio (5.5), and fairly weak interest coverage, since EBIT is just 0.34 times the interest expense. The debt burden here is substantial. Even worse, Select Interior Concepts saw its EBIT tank 65% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Select Interior Concepts 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Select Interior Concepts actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, Select Interior Concepts’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Select Interior Concepts stock a bit risky. Some people like that sort of risk, but we’re mindful of the potential pitfalls, so we’d probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.