Is SFS Group (VTX:SFSN) Using Too Much Debt?

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.' 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. As with many other companies SFS Group AG (VTX:SFSN) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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.

See our latest analysis for SFS Group

How Much Debt Does SFS Group Carry?

As you can see below, SFS Group had CHF140.9m of debt at June 2020, down from CHF183.1m a year prior. However, it also had CHF129.5m in cash, and so its net debt is CHF11.4m.

How Strong Is SFS Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that SFS Group had liabilities of CHF241.5m due within 12 months and liabilities of CHF198.0m due beyond that. Offsetting these obligations, it had cash of CHF129.5m as well as receivables valued at CHF287.7m due within 12 months. So it has liabilities totalling CHF22.3m more than its cash and near-term receivables, combined.

This state of affairs indicates that SFS Group's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the CHF3.91b company is struggling for cash, we still think it's worth monitoring its balance sheet. Carrying virtually no net debt, SFS Group has a very light debt load indeed.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SFS Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.038 and EBIT of 43.2 times the interest expense. So relative to past earnings, the debt load seems trivial. On the other hand, SFS Group saw its EBIT drop by 9.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SFS Group 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. During the last three years, SFS Group produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, SFS Group's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. When we consider the range of factors above, it looks like SFS Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 1 warning sign for SFS Group that 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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