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. As with many other companies SunCoke Energy, Inc. (NYSE:SXC) makes use of debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does SunCoke Energy Carry?
The chart below, which you can click on for greater detail, shows that SunCoke Energy had US$833.1m in debt in June 2019; about the same as the year before. However, it does have US$102.2m in cash offsetting this, leading to net debt of about US$730.9m.
How Healthy Is SunCoke Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that SunCoke Energy had liabilities of US$209.6m due within 12 months and liabilities of US$1.15b due beyond that. Offsetting these obligations, it had cash of US$102.2m as well as receivables valued at US$102.1m due within 12 months. So it has liabilities totalling US$1.16b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$502.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet." So we'd watch its balance sheet closely, without a doubt At the end of the day, SunCoke Energy would probably need a major re-capitalization if its creditors were to demand repayment.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While SunCoke Energy's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that SunCoke Energy saw its EBIT drop by 19% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. 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 SunCoke Energy 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, SunCoke Energy's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both SunCoke Energy's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Taking into account all the aforementioned factors, it looks like SunCoke Energy has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given our concerns about SunCoke Energy's debt levels, it seems only prudent to check if insiders have been ditching the stock.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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