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Is Sims (ASX:SGM) A Risky Investment?

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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.' 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. We note that Sims Limited (ASX:SGM) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sims

What Is Sims's Net Debt?

The image below, which you can click on for greater detail, shows that Sims had debt of AU$126.8m at the end of December 2021, a reduction from AU$144.0m over a year. But on the other hand it also has AU$213.8m in cash, leading to a AU$87.0m net cash position.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At Sims' Liabilities

Zooming in on the latest balance sheet data, we can see that Sims had liabilities of AU$830.6m due within 12 months and liabilities of AU$678.8m due beyond that. On the other hand, it had cash of AU$213.8m and AU$556.0m worth of receivables due within a year. So it has liabilities totalling AU$739.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Sims is worth AU$3.35b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, Sims boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Sims made a loss at the EBIT level, last year, it was also good to see that it generated AU$285m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sims'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Sims may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent year, Sims recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

Although Sims's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$87.0m. So we don't have any problem with Sims's use of debt. 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. Be aware that Sims is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.