Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say this when he says “The biggest risk in investing is not price volatility, but if you will suffer a loss. permanent capital “. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We can see that Spirax-Sarco Engineering plc (LON: SPX) uses debt in its business. But does this debt worry shareholders?

What risk does debt entail?

Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting their shareholders because lenders are forcing them to raise capital at a ridiculous price. Of course, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first look at cash and debt levels, together.

See our latest analysis for Spirax-Sarco Engineering

What is Spirax-Sarco Engineering’s net debt?

As you can see below, Spirax-Sarco Engineering was in debt of £ 446.4million in June 2021, up from £ 646.0million the year before. However, he has £ 253.6million in cash offsetting this, leading to net debt of around £ 192.8million.

A look at the responsibilities of Spirax-Sarco Engineering

The latest balance sheet data shows Spirax-Sarco Engineering had debts of £ 370.0 million due within one year, and debts of £ 454.0 million due thereafter. On the other hand, he had cash of £ 253.6million and £ 244.0million in less than one year receivables. It therefore has liabilities totaling £ 326.4million more than its cash and short-term receivables combined.

Considering Spirax-Sarco Engineering has a whopping market cap of £ 11.8 billion, it’s hard to believe these liabilities pose a threat. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time.

In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).

Spirax-Sarco Engineering has a low net debt / EBITDA ratio of only 0.59. And its EBIT easily covers its interest costs, being 44.4 times higher. So we’re pretty relaxed about its ultra-conservative use of debt. Another good thing is that Spirax-Sarco Engineering has increased its EBIT to 10% over the past year, further increasing its ability to manage debt. When analyzing debt levels, the balance sheet is the obvious place to start. But ultimately, the company’s future profitability will decide whether Spirax-Sarco Engineering can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.

But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. During the last three years Spirax-Sarco Engineering has recorded free cash flow representing 71% of its EBIT, which is close to normal, given that free cash flow excludes interest and taxes. This hard cash allows him to reduce his debt whenever he wants.

Our point of view

Spirax-Sarco Engineering’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. And this is only the beginning of good news as its conversion from EBIT to free cash flow is also very encouraging. Looking at the big picture, we think Spirax-Sarco Engineering’s use of debt seems very reasonable and we are not concerned about this. While debt comes with risk, when used wisely, it can also generate a better return on equity. Over time, stock prices tend to follow earnings per share, so if you are interested in Spirax-Sarco Engineering, you can click here to view an interactive graph of its historical earnings per share.

If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow-growing stocks.

Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.