David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Sims Limited (ASX:SGM) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Sims's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Sims had debt of AU$144.0m, up from AU$71.7m in one year. But it also has AU$332.2m in cash to offset that, meaning it has AU$188.2m net cash.
How Strong Is Sims' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sims had liabilities of AU$598.1m due within 12 months and liabilities of AU$625.0m due beyond that. On the other hand, it had cash of AU$332.2m and AU$398.1m worth of receivables due within a year. So its liabilities total AU$492.8m more than the combination of its cash and short-term receivables.
Given Sims has a market capitalization of AU$2.89b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Sims boasts net cash, so it's fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sims 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.
In the last year Sims had a loss before interest and tax, and actually shrunk its revenue by 23%, to AU$4.7b. To be frank that doesn't bode well.
So How Risky Is Sims?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that Sims had an earnings before interest and tax (EBIT) loss, over the last year. And over the same period it saw negative free cash outflow of AU$6.1m and booked a AU$121m accounting loss. With only AU$188.2m on the balance sheet, it would appear that its going to need to raise capital again soon. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. For riskier companies like Sims I always like to keep an eye on the long term profit and revenue trends. Fortunately, you can click to see our interactive graph of its profit, revenue, and operating cashflow.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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