David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that First Sponsor Group Limited (SGX:ADN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does First Sponsor Group Carry?
As you can see below, at the end of June 2019, First Sponsor Group had S$787.9m of debt, up from S$653.4m a year ago. Click the image for more detail. However, it does have S$257.9m in cash offsetting this, leading to net debt of about S$530.0m.
How Healthy Is First Sponsor Group's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that First Sponsor Group had liabilities of S$620.3m due within 12 months and liabilities of S$656.4m due beyond that. Offsetting this, it had S$257.9m in cash and S$330.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$687.9m.
This is a mountain of leverage relative to its market capitalization of S$1.03b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
First Sponsor Group's net debt is 3.4 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. First Sponsor Group grew its EBIT by 3.3% 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 ultimately the future profitability of the business will decide if First Sponsor Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, First Sponsor Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
We'd go so far as to say First Sponsor Group's conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that First Sponsor Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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