The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Smart Parking Limited (ASX:SPZ) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Smart Parking Carry?
The chart below, which you can click on for greater detail, shows that Smart Parking had AU$2.56m in debt in December 2021; about the same as the year before. However, its balance sheet shows it holds AU$11.8m in cash, so it actually has AU$9.21m net cash.
A Look At Smart Parking's Liabilities
The latest balance sheet data shows that Smart Parking had liabilities of AU$11.3m due within a year, and liabilities of AU$15.1m falling due after that. Offsetting these obligations, it had cash of AU$11.8m as well as receivables valued at AU$8.49m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.19m.
Since publicly traded Smart Parking shares are worth a total of AU$63.1m, it seems unlikely that this level of liabilities would be a major threat. 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, Smart Parking also has more cash than debt, so we're pretty confident it can manage its debt safely.
Notably, Smart Parking's EBIT launched higher than Elon Musk, gaining a whopping 325% on last year. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Smart Parking will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Smart Parking 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. Happily for any shareholders, Smart Parking actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Smart Parking has AU$9.21m in net cash. And it impressed us with free cash flow of AU$7.0m, being 253% of its EBIT. So is Smart Parking's debt a risk? It doesn't seem so to us. 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. For instance, we've identified 2 warning signs for Smart Parking that you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.