Is Straits Trading (SGX:S20) Using Too Much Debt?
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. 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 The Straits Trading Company Limited (SGX:S20) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Straits Trading
What Is Straits Trading's Net Debt?
The chart below, which you can click on for greater detail, shows that Straits Trading had S$902.8m in debt in June 2019; about the same as the year before. However, it also had S$354.2m in cash, and so its net debt is S$548.5m.
How Strong Is Straits Trading's Balance Sheet?
We can see from the most recent balance sheet that Straits Trading had liabilities of S$316.5m falling due within a year, and liabilities of S$687.9m due beyond that. Offsetting this, it had S$354.2m in cash and S$97.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$552.8m.
This is a mountain of leverage relative to its market capitalization of S$851.0m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
With a net debt to EBITDA ratio of 6.0, it's fair to say Straits Trading does have a significant amount of debt. However, its interest coverage of 3.1 is reasonably strong, which is a good sign. The good news is that Straits Trading grew its EBIT a smooth 69% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Straits Trading's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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 last three years, Straits Trading saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both Straits Trading's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Straits Trading stock 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.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.
