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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Synex International Inc. (TSE:SXI) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Synex International's Net Debt?
The image below, which you can click on for greater detail, shows that Synex International had debt of CA$12.8m at the end of March 2021, a reduction from CA$13.7m over a year. And it doesn't have much cash, so its net debt is about the same.
How Healthy Is Synex International's Balance Sheet?
We can see from the most recent balance sheet that Synex International had liabilities of CA$11.1m falling due within a year, and liabilities of CA$3.57m due beyond that. On the other hand, it had cash of CA$125.0k and CA$647.6k worth of receivables due within a year. So its liabilities total CA$13.9m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's CA$12.3m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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.
Synex International shareholders face the double whammy of a high net debt to EBITDA ratio (9.4), and fairly weak interest coverage, since EBIT is just 0.60 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Synex International is that it turned last year's EBIT loss into a gain of CA$343k, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Synex International's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Synex International produced sturdy free cash flow equating to 62% 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.
On the face of it, Synex International's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Synex International's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. To that end, you should learn about the 3 warning signs we've spotted with Synex International (including 2 which are a bit unpleasant) .
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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