Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Sensient Technologies Corporation (NYSE:SXT) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

How Much Debt Does Sensient Technologies Carry?

As you can see below, Sensient Technologies had US$658.5m of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$28.9m in cash leading to net debt of about US$629.6m.

A Look At Sensient Technologies' Liabilities

We can see from the most recent balance sheet that Sensient Technologies had liabilities of US$236.3m falling due within a year, and liabilities of US$724.9m due beyond that. Offsetting these obligations, it had cash of US$28.9m as well as receivables valued at US$272.2m due within 12 months. So it has liabilities totalling US$660.1m more than its cash and near-term receivables, combined.

Sensient Technologies has a market capitalization of US$2.92b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).

Sensient Technologies has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.2 suggests it can easily service that debt. Unfortunately, Sensient Technologies saw its EBIT slide 8.7% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sensient Technologies can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Sensient Technologies created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

While Sensient Technologies's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. At least its interest cover gives us reason to be optimistic. Taking the abovementioned factors together we do think Sensient Technologies's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Sensient Technologies that you should be aware of.

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.

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.