These 4 Measures Indicate That Sutton Harbour Group (LON:SUH) Is Using Debt In A Risky Way

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. As with many other companies Sutton Harbour Group plc (LON:SUH) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sutton Harbour Group

What Is Sutton Harbour Group's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sutton Harbour Group had UK£24.3m of debt, an increase on UK£23.0m, over one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Sutton Harbour Group's Balance Sheet?

According to the last reported balance sheet, Sutton Harbour Group had liabilities of UK£2.16m due within 12 months, and liabilities of UK£26.6m due beyond 12 months. On the other hand, it had cash of UK£177.0k and UK£2.36m worth of receivables due within a year. So its liabilities total UK£26.2m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of UK£23.2m, we think shareholders really should watch Sutton Harbour Group's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sutton Harbour Group shareholders face the double whammy of a high net debt to EBITDA ratio (21.7), and fairly weak interest coverage, since EBIT is just 0.96 times the interest expense. The debt burden here is substantial. Even worse, Sutton Harbour Group saw its EBIT tank 34% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sutton Harbour Group will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sutton Harbour Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Sutton Harbour Group's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We should also note that Infrastructure industry companies like Sutton Harbour Group commonly do use debt without problems. We think the chances that Sutton Harbour Group has too much debt a very significant. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Sutton Harbour Group is showing 3 warning signs in our investment analysis , and 2 of those don't sit too well with us...

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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