Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Sunningdale Tech Ltd (SGX:BHQ) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Sunningdale Tech's Net Debt?
The image below, which you can click on for greater detail, shows that Sunningdale Tech had debt of S$100.7m at the end of June 2019, a reduction from S$105.7m over a year. However, because it has a cash reserve of S$91.8m, its net debt is less, at about S$8.89m.
How Strong Is Sunningdale Tech's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sunningdale Tech had liabilities of S$303.3m due within 12 months and liabilities of S$48.6m due beyond that. On the other hand, it had cash of S$91.8m and S$267.3m worth of receivables due within a year. So it can boast S$7.18m more liquid assets than total liabilities.
This short term liquidity is a sign that Sunningdale Tech could probably pay off its debt with ease, as its balance sheet is far from stretched.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Sunningdale Tech's low debt to EBITDA ratio of 0.19 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.3 last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Shareholders should be aware that Sunningdale Tech's EBIT was down 50% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sunningdale Tech can strengthen its balance sheet over time. 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. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Sunningdale Tech reported free cash flow worth 13% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Sunningdale Tech's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability handle its debt, based on its EBITDA, isn't too shabby at all. When we consider all the factors discussed, it seems to us that Sunningdale Tech is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Sunningdale Tech's dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.