Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 Space Group Holdings Limited (HKG:2448) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 Space Group Holdings’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Space Group Holdings had MO$222.0m of debt, an increase on MO$147, over one year. On the flip side, it has MO$15.2m in cash leading to net debt of about MO$206.8m.
How Healthy Is Space Group Holdings’s Balance Sheet?
The latest balance sheet data shows that Space Group Holdings had liabilities of MO$278.4m due within a year, and liabilities of MO$3.42m falling due after that. Offsetting this, it had MO$15.2m in cash and MO$486.5m in receivables that were due within 12 months. So it actually has MO$220.0m more liquid assets than total liabilities.
This surplus suggests that Space Group Holdings is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Space Group Holdings has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 12.2 times its interest expense, implying the company isn’t really paying full freight on that debt. Even if not sustainable, that is a good sign. Importantly, Space Group Holdings grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 3 warning signs for Space Group Holdings (of which 2 are major) which any shareholder or potential investor should be aware of.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Space Group Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Happily, Space Group Holdings’s impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that Space Group Holdings takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Space Group Holdings’s earnings per share history for free.
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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