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. As with many other companies Southern Energy Holdings Group Limited (HKG:1573) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Southern Energy Holdings Group’s Debt?
The image below, which you can click on for greater detail, shows that Southern Energy Holdings Group had debt of CN¥158.2m at the end of June 2019, a reduction from CN¥300.5m over a year. However, it does have CN¥230.7m in cash offsetting this, leading to net cash of CN¥72.5m.
How Healthy Is Southern Energy Holdings Group’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Southern Energy Holdings Group had liabilities of CN¥315.9m due within 12 months and liabilities of CN¥55.5m due beyond that. Offsetting these obligations, it had cash of CN¥230.7m as well as receivables valued at CN¥364.0k due within 12 months. So its liabilities total CN¥140.4m more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Southern Energy Holdings Group is worth CN¥511.4m, 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, Southern Energy Holdings Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
On the other hand, Southern Energy Holdings Group’s EBIT dived 16%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since Southern Energy Holdings Group will need earnings to service that debt. 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. While Southern Energy Holdings Group has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Southern Energy Holdings Group recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although Southern Energy Holdings Group’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥72.5m. So we are not troubled with Southern Energy Holdings Group’s debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we’ve spotted with Southern Energy Holdings Group .
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.
If you spot an error that warrants correction, please contact the editor at email@example.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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.