Super Retail Group (ASX:SUL) Seems To Use Debt Quite Sensibly

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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Super Retail Group Limited (ASX:SUL) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Super Retail Group

What Is Super Retail Group’s Net Debt?

The image below, which you can click on for greater detail, shows that Super Retail Group had debt of AU$308.9m at the end of December 2019, a reduction from AU$350.8m over a year. However, it also had AU$57.1m in cash, and so its net debt is AU$251.8m.

ASX:SUL Historical Debt June 4th 2020
ASX:SUL Historical Debt June 4th 2020

How Healthy Is Super Retail Group’s Balance Sheet?

The latest balance sheet data shows that Super Retail Group had liabilities of AU$847.3m due within a year, and liabilities of AU$1.08b falling due after that. Offsetting these obligations, it had cash of AU$57.1m as well as receivables valued at AU$47.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$1.82b.

Given this deficit is actually higher than the company’s market capitalization of AU$1.66b, we think shareholders really should watch Super Retail Group’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Super Retail Group’s low debt to EBITDA ratio of 0.95 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.5 times last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. We saw Super Retail Group grow its EBIT by 9.9% in the last twelve months. That’s far from incredible but it is a good thing, when it comes to paying off debt. 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 Super Retail Group 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 company can only pay off debt with cold hard cash, not accounting profits. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Super Retail Group recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Super Retail Group was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren’t so heartening. To be specific, it seems about as good at staying on top of its total liabilities as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about Super Retail Group’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 1 warning sign for Super Retail Group you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.