Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that SysGroup plc (LON:SYS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is SysGroup's Net Debt?
The image below, which you can click on for greater detail, shows that SysGroup had debt of UK£1.51m at the end of September 2019, a reduction from UK£1.99m over a year. But on the other hand it also has UK£2.65m in cash, leading to a UK£1.14m net cash position.
A Look At SysGroup's Liabilities
We can see from the most recent balance sheet that SysGroup had liabilities of UK£6.42m falling due within a year, and liabilities of UK£3.11m due beyond that. Offsetting this, it had UK£2.65m in cash and UK£1.17m in receivables that were due within 12 months. So it has liabilities totalling UK£5.72m more than its cash and near-term receivables, combined.
This deficit isn't so bad because SysGroup is worth UK£17.3m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, SysGroup also has more cash than debt, so we're pretty confident it can manage its debt safely.
Shareholders should be aware that SysGroup's EBIT was down 43% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine SysGroup'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. SysGroup 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. Over the last two years, SysGroup actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although SysGroup's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£1.14m. The cherry on top was that in converted 245% of that EBIT to free cash flow, bringing in UK£902k. So although we see some areas for improvement, we're not too worried about SysGroup's balance sheet. 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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