Somi Conveyor Beltings (NSE: SOMICONVEY) seems to be using debt quite wisely
Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. Mostly, Somi Conveyor Beltings Limited (NSE: SOMICONVEY) is in debt. But the most important question is: what risk does this debt create?
When is debt a problem?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
See our latest review for Somi conveyor belts
What is the net debt of Somi Conveyor Beltings?
You can click on the graph below for historical figures, but it shows Somi Conveyor Beltings had a debt of 222.1 million yen in March 2021, down from 235.7 million yen a year earlier. However, he also had 29.4 million yen in cash, so his net debt is 192.7 million yen.
How healthy is Somi Conveyor Beltings’ track record?
According to the latest published balance sheet, Somi Conveyor Beltings had a liability of 315.5 million yen due within 12 months and a liability of 62.4 million yen due beyond 12 months. In compensation for these obligations, it had cash of 29.4 million as well as receivables valued at 295.0 million at 12 months. Its liabilities therefore total â¹ 53.6m more than the combination of its cash and short-term receivables.
Given that the listed Somi Conveyor Beltings shares are worth a total of 600.2 million yen, it seems unlikely that this level of liabilities is a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While Somi Conveyor Beltings’ debt to EBITDA ratio (3.0) suggests that it is using some debt, its interest coverage is very low at 1.7, suggesting high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Another investor concern could be that Somi Conveyor Beltings EBIT fell 10% last year. If things continue like this, managing the debt will be about as easy as putting an angry house cat in its travel box. When analyzing debt levels, the balance sheet is the obvious starting point. But it is the profits of Somi Conveyor Beltings that will influence the balance sheet in the future. So if you want to know more about its profits, it may be worth checking out this chart of its long term profit trend.
Finally, while the IRS may love accounting profits, lenders only accept hard cash. We must therefore clearly verify whether this EBIT generates a corresponding free cash flow. Over the past three years, Somi Conveyor Beltings has recorded free cash flow corresponding to 69% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
Somi Conveyor Beltings’ interest coverage was really negative in this analysis, although the other factors we considered were considerably better. In particular, we are dazzled by its conversion of EBIT into free cash flow. When we consider all of the factors mentioned above, we feel a little cautious about Somi Conveyor Beltings’ use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. Concrete example: we have spotted 2 warning signs for Somi conveyor belts you need to be aware of it, and one of them is of concern.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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