Some say that volatility, not debt, is the best way to think about risk as an investor, but Warren Buffett once said, “Volatility is far from synonymous with risk.” When we think about how risky a company is, we always like to look at its level of debt, as excessive debt can lead to ruin. We can see that Stepan Company (NYSE:SCL) does indeed use debt in its business. But is this debt a cause for concern for shareholders?

Why is debt risky?

Debt is a means of helping businesses grow, but if a company is unable to repay its creditors, it is at their mercy. In a worst-case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is that a company must dilute shareholders at a cheap share price just to get debt under control. The advantage of debt, of course, is that it often represents cheap capital, particularly when it replaces a company’s dilution with the ability to reinvest at a high rate of return. When we examine debt levels, we first look at both cash and debt levels together.

Check out our latest analysis for Stepan

How much debt does Stepan have?

As you can see below, Stepan had $657.1 million in debt as of June 2024, which is about the same as last year. You can click on the chart to see more details. However, that compares to $124.7 million in cash, resulting in net debt of about $532.4 million.

How strong is Stepan’s balance sheet?

From the latest balance sheet data, Stepan had liabilities of $655.2 million due within one year and accounts receivable of $501.0 million due later. On the other hand, the company had cash of $124.7 million and accounts receivable of $437.3 million due within one year. So, the company’s liabilities are $594.1 million more than its cash and near-term receivables combined.

While this may seem like a lot, it’s not so bad since Stepan has a market cap of $1.67 billion and could therefore probably strengthen its balance sheet through a capital raise if it needed to. But it’s clear that we should take a close look at whether the company can manage its debt without dilution.

We measure a company’s debt load relative to its earnings power by dividing its net debt by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest expenses (interest cover). This way, we take into account both the absolute amount of debt and the interest rates paid on it.

Stepan has a net debt to EBITDA ratio of 2.9, which suggests that the company uses a fairly high level of leverage to boost its earnings. On the positive side, its EBIT was 7.1 times its interest expense, and its net debt to EBITDA ratio was quite high at 2.9. Importantly, Stepan’s EBIT is down an incredible 32% over the last twelve months. If this earnings trend continues, paying off its debt will be about as easy as herding cats on a rollercoaster. When analyzing debt levels, the balance sheet is the obvious place to start. But it’s future earnings more than anything else that will determine Stepan’s ability to maintain a healthy balance sheet going forward, so if you want to know what the professionals think, you might find this free report on analyst earnings forecasts interesting.

After all, a company can only pay off its debt with cold hard cash, not accounting profits, so we really need to check whether that EBIT translates into corresponding free cash flow. Over the past three years, Stepan has burned through a lot of cash. While investors no doubt expect this situation to reverse in due course, it clearly means that using debt is riskier for the company.

Our view

Frankly, both Stepan’s conversion of EBIT to free cash flow and his track record of (not) growing his EBIT make us a little unhappy with his debt levels. But at least he’s doing a pretty good job of covering his interest expenses with his EBIT; that’s encouraging. We’re pretty sure that his balance sheet health makes us consider Stepan to be quite risky. As such, we’re almost as wary of this stock as a hungry kitten is of falling into its owner’s fish pond: once burned, once burned, again, as the saying goes. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, every company can have risks that exist off the balance sheet. These risks can be difficult to identify. Every company has them, and we’ve identified them. 3 warning signs for Stepan You should know about this.

Ultimately, sometimes it’s easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with no net debt. 100% freeat the moment.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.