David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Sunway Berhad (KLSE:SUNWAY) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Sunway Berhad Carry?
The image below, which you can click on for greater detail, shows that Sunway Berhad had debt of RM6.82b at the end of March 2021, a reduction from RM10.3b over a year. However, it also had RM2.06b in cash, and so its net debt is RM4.76b.
How Healthy Is Sunway Berhad's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Sunway Berhad had liabilities of RM8.12b due within 12 months and liabilities of RM2.25b due beyond that. On the other hand, it had cash of RM2.06b and RM2.48b worth of receivables due within a year. So its liabilities total RM5.83b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of RM7.82b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
As it happens Sunway Berhad has a fairly concerning net debt to EBITDA ratio of 17.4 but very strong interest coverage of 1k. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Sunway Berhad's EBIT fell a jaw-dropping 72% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sunway Berhad's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Sunway Berhad actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
We feel some trepidation about Sunway Berhad's difficulty EBIT growth rate, but we've got positives to focus on, too. To wit both its interest cover and conversion of EBIT to free cash flow were encouraging signs. Taking the abovementioned factors together we do think Sunway Berhad's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For instance, we've identified 3 warning signs for Sunway Berhad (1 can't be ignored) you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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