These 4 Measures Indicate That L.S. Starrett (NYSE:SCX) Is Using Debt Extensively

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that The L.S. Starrett Company (NYSE:SCX) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for L.S. Starrett

How Much Debt Does L.S. Starrett Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2019 L.S. Starrett had US$23.1m of debt, an increase on US$20.4m, over one year. However, it also had US$10.5m in cash, and so its net debt is US$12.6m.

A Look At L.S. Starrett's Liabilities

We can see from the most recent balance sheet that L.S. Starrett had liabilities of US$30.3m falling due within a year, and liabilities of US$78.0m due beyond that. Offsetting this, it had US$10.5m in cash and US$31.3m in receivables that were due within 12 months. So it has liabilities totalling US$66.5m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$41.3m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, L.S. Starrett would likely require a major re-capitalisation if it had to pay its creditors today.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

L.S. Starrett's net debt is only 0.69 times its EBITDA. And its EBIT covers its interest expense a whopping 12.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, L.S. Starrett grew its EBIT by 117% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since L.S. Starrett will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, L.S. Starrett saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, L.S. Starrett's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making L.S. Starrett 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. Given our hesitation about the stock, it would be good to know if L.S. Starrett insiders have sold any shares recently. You click here to find out if insiders have sold recently.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.