Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. Importantly, Sirma Group Holding AD (BUL:SKK) does carry debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Sirma Group Holding AD Carry?
As you can see below, at the end of September 2020, Sirma Group Holding AD had лв23.1m of debt, up from лв21.7m a year ago. Click the image for more detail. However, it also had лв7.65m in cash, and so its net debt is лв15.5m.
How Healthy Is Sirma Group Holding AD's Balance Sheet?
The latest balance sheet data shows that Sirma Group Holding AD had liabilities of лв22.4m due within a year, and liabilities of лв9.95m falling due after that. On the other hand, it had cash of лв7.65m and лв13.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by лв11.5m.
While this might seem like a lot, it is not so bad since Sirma Group Holding AD has a market capitalization of лв32.9m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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).
Sirma Group Holding AD has a debt to EBITDA ratio of 2.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 22.0 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Shareholders should be aware that Sirma Group Holding AD's EBIT was down 26% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Sirma Group Holding AD 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Sirma Group Holding AD recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Neither Sirma Group Holding AD's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Sirma Group Holding AD's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Sirma Group Holding AD you should be aware of.
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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