These 4 Measures Indicate That Sunland Group (ASX:SDG) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Sunland Group Limited (ASX:SDG) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sunland Group

What Is Sunland Group's Net Debt?

The image below, which you can click on for greater detail, shows that Sunland Group had debt of AU$149.9m at the end of December 2020, a reduction from AU$181.6m over a year. However, it does have AU$40.2m in cash offsetting this, leading to net debt of about AU$109.7m.

How Healthy Is Sunland Group's Balance Sheet?

The latest balance sheet data shows that Sunland Group had liabilities of AU$24.1m due within a year, and liabilities of AU$164.1m falling due after that. Offsetting these obligations, it had cash of AU$40.2m as well as receivables valued at AU$7.99m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$140.0m.

This deficit isn't so bad because Sunland Group is worth AU$303.8m, and thus could probably raise enough capital to shore up 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.

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).

As it happens Sunland Group has a fairly concerning net debt to EBITDA ratio of 6.4 but very strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Sunland Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sunland Group'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Sunland Group actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Sunland Group's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its net debt to EBITDA has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Sunland Group can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Sunland Group you should know about.

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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