Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Swallowfield plc (LON:SWL) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Swallowfield
What Is Swallowfield's Debt?
As you can see below, at the end of January 2019, Swallowfield had UK£3.76m of debt, up from UK£1.78m a year ago. Click the image for more detail. However, because it has a cash reserve of UK£1.75m, its net debt is less, at about UK£2.02m.
How Healthy Is Swallowfield's Balance Sheet?
The latest balance sheet data shows that Swallowfield had liabilities of UK£23.5m due within a year, and liabilities of UK£9.65m falling due after that. Offsetting this, it had UK£1.75m in cash and UK£15.3m in receivables that were due within 12 months. So it has liabilities totalling UK£16.1m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Swallowfield is worth UK£33.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).