We Think Sterling Group Holdings (HKG:1825) Is Taking Some Risk With Its Debt

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.' 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. We note that Sterling Group Holdings Limited (HKG:1825) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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 Sterling Group Holdings

How Much Debt Does Sterling Group Holdings Carry?

As you can see below, Sterling Group Holdings had HK$280.7m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$67.7m in cash leading to net debt of about HK$213.0m.

How Healthy Is Sterling Group Holdings's Balance Sheet?

The latest balance sheet data shows that Sterling Group Holdings had liabilities of HK$329.7m due within a year, and liabilities of HK$42.1m falling due after that. Offsetting this, it had HK$67.7m in cash and HK$193.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$110.9m.

This deficit casts a shadow over the HK$47.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Sterling Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Sterling Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (19.7), and fairly weak interest coverage, since EBIT is just 0.35 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Sterling Group Holdings is that it turned last year's EBIT loss into a gain of HK$3.0m, over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sterling Group Holdings's earnings that will influence how the balance sheet holds up in the future. 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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Sterling Group Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Sterling Group Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Sterling Group Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Sterling Group Holdings (2 don't sit too well with us!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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