Here's Why Sirius Real Estate (LON:SRE) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Sirius Real Estate Limited (LON:SRE) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sirius Real Estate

What Is Sirius Real Estate's Net Debt?

As you can see below, Sirius Real Estate had €469.3m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of €65.7m, its net debt is less, at about €403.6m.

A Look At Sirius Real Estate's Liabilities

The latest balance sheet data shows that Sirius Real Estate had liabilities of €68.0m due within a year, and liabilities of €525.2m falling due after that. On the other hand, it had cash of €65.7m and €17.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €509.8m.

This deficit isn't so bad because Sirius Real Estate is worth €1.50b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

As it happens Sirius Real Estate has a fairly concerning net debt to EBITDA ratio of 5.6 but very strong interest coverage of 10.7. So either it has access to very cheap long term debt or that interest expense is going to grow! Sirius Real Estate grew its EBIT by 8.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sirius Real Estate'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sirius Real Estate generated free cash flow amounting to a very robust 84% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Sirius Real Estate's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. 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 Sirius Real Estate can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 4 warning signs we've spotted with Sirius Real Estate (including 1 which shouldn't be ignored) .

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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