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. 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 can see that Seroja Investments Limited (SGX:IW5) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Seroja Investments Carry?
You can click the graphic below for the historical numbers, but it shows that Seroja Investments had US$2.19m of debt in June 2019, down from US$9.38m, one year before. But it also has US$5.65m in cash to offset that, meaning it has US$3.46m net cash.
How Strong Is Seroja Investments's Balance Sheet?
We can see from the most recent balance sheet that Seroja Investments had liabilities of US$7.23m falling due within a year, and liabilities of US$799.0k due beyond that. On the other hand, it had cash of US$5.65m and US$9.46m worth of receivables due within a year. So it actually has US$7.07m more liquid assets than total liabilities.
This luscious liquidity implies that Seroja Investments's balance sheet is sturdy like a giant sequoia tree. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Seroja Investments has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Seroja Investments's load is not too heavy, because its EBIT was down 29% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Seroja Investments will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Seroja Investments has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last two years, Seroja Investments actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While we empathize with investors who find debt concerning, you should keep in mind that Seroja Investments has net cash of US$3.46m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of US$14m, being 243% of its EBIT. So we don't think Seroja Investments's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Seroja Investments's earnings per share history for free.
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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