Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Seven Group Holdings Limited (ASX:SVW) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Seven Group Holdings's Net Debt?
As you can see below, Seven Group Holdings had AU$2.23b of debt at December 2018, down from AU$2.41b a year prior. On the flip side, it has AU$78.8m in cash leading to net debt of about AU$2.15b.
A Look At Seven Group Holdings's Liabilities
The latest balance sheet data shows that Seven Group Holdings had liabilities of AU$713.1m due within a year, and liabilities of AU$2.59b falling due after that. On the other hand, it had cash of AU$78.8m and AU$497.1m worth of receivables due within a year. So its liabilities total AU$2.72b more than the combination of its cash and short-term receivables.
Seven Group Holdings has a market capitalization of AU$5.53b, 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).
Seven Group Holdings's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.3 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Notably, Seven Group Holdings's EBIT launched higher than Elon Musk, gaining a whopping 102% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Seven Group Holdings'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Seven Group Holdings recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
On our analysis Seven Group Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. When we consider all the elements mentioned above, it seems to us that Seven Group Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that Seven Group Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.