The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Standard Motor Products, Inc. (NYSE:SMP) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Standard Motor Products's Debt?
The image below, which you can click on for greater detail, shows that at March 2025 Standard Motor Products had debt of US$650.6m, up from US$214.9m in one year. However, it does have US$50.3m in cash offsetting this, leading to net debt of about US$600.3m.
How Healthy Is Standard Motor Products' Balance Sheet?
The latest balance sheet data shows that Standard Motor Products had liabilities of US$437.4m due within a year, and liabilities of US$836.3m falling due after that. Offsetting this, it had US$50.3m in cash and US$280.8m in receivables that were due within 12 months. So its liabilities total US$942.6m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's US$711.3m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
View our latest analysis for Standard Motor Products
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.
Standard Motor Products has net debt to EBITDA of 3.3 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 8.0 suggests it can easily service that debt. Standard Motor Products grew its EBIT by 8.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Standard Motor Products's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Standard Motor Products recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
We'd go so far as to say Standard Motor Products's level of total liabilities was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Standard Motor Products's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Standard Motor Products (1 is concerning) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.