We Think SRE Holdings (TSE:2980) Can Stay On Top Of Its Debt

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.' 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. Importantly, SRE Holdings Corporation (TSE:2980) does carry debt. But is this debt a concern to shareholders?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SRE Holdings

What Is SRE Holdings's Debt?

The chart below, which you can click on for greater detail, shows that SRE Holdings had JP¥8.42b in debt in March 2024; about the same as the year before. However, because it has a cash reserve of JP¥3.36b, its net debt is less, at about JP¥5.06b.

How Strong Is SRE Holdings' Balance Sheet?

We can see from the most recent balance sheet that SRE Holdings had liabilities of JP¥3.89b falling due within a year, and liabilities of JP¥7.67b due beyond that. On the other hand, it had cash of JP¥3.36b and JP¥2.30b worth of receivables due within a year. So it has liabilities totalling JP¥5.90b more than its cash and near-term receivables, combined.

Since publicly traded SRE Holdings shares are worth a total of JP¥85.8b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

We'd say that SRE Holdings's moderate net debt to EBITDA ratio ( being 2.0), indicates prudence when it comes to debt. And its strong interest cover of 26.7 times, makes us even more comfortable. It is well worth noting that SRE Holdings's EBIT shot up like bamboo after rain, gaining 31% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine SRE Holdings'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, SRE Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Happily, SRE Holdings's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that SRE Holdings can comfortably handle its current debt levels. 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. 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. Case in point: We've spotted 2 warning signs for SRE Holdings you should be aware of, and 1 of them is a bit concerning.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com