Does Sims (ASX:SGM) Have A Healthy Balance Sheet?

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.' 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. We can see that Sims Limited (ASX:SGM) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sims

What Is Sims's Debt?

As you can see below, at the end of December 2022, Sims had AU$421.0m of debt, up from AU$126.8m a year ago. Click the image for more detail. However, it does have AU$407.2m in cash offsetting this, leading to net debt of about AU$13.8m.

A Look At Sims' Liabilities

According to the last reported balance sheet, Sims had liabilities of AU$835.8m due within 12 months, and liabilities of AU$954.3m due beyond 12 months. Offsetting this, it had AU$407.2m in cash and AU$600.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$782.0m.

Sims has a market capitalization of AU$2.87b, so it could very likely raise cash to ameliorate 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. But either way, Sims has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). 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).

Sims's debt of just 0.043 times EBITDA is really very modest. And this impression is enhanced by its strong EBIT which covers interest costs 8.4 times. In fact Sims's saving grace is its low debt levels, because its EBIT has tanked 31% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sims's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last two years, Sims produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Sims's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its conversion of EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Sims is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. Case in point: We've spotted 2 warning signs for Sims you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.