Here's Why SDS Group Berhad (KLSE:SDS) Has A Meaningful Debt Burden

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.' 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. Importantly, SDS Group Berhad (KLSE:SDS) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for SDS Group Berhad

What Is SDS Group Berhad's Debt?

The chart below, which you can click on for greater detail, shows that SDS Group Berhad had RM28.8m in debt in September 2020; about the same as the year before. However, it does have RM15.7m in cash offsetting this, leading to net debt of about RM13.1m.

How Strong Is SDS Group Berhad's Balance Sheet?

We can see from the most recent balance sheet that SDS Group Berhad had liabilities of RM34.8m falling due within a year, and liabilities of RM41.6m due beyond that. On the other hand, it had cash of RM15.7m and RM14.0m worth of receivables due within a year. So it has liabilities totalling RM46.7m more than its cash and near-term receivables, combined.

SDS Group Berhad has a market capitalization of RM87.3m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

SDS Group Berhad has a very low debt to EBITDA ratio of 0.91 so it is strange to see weak interest coverage, with last year's EBIT being only 2.5 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that SDS Group Berhad's EBIT was down 25% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since SDS Group Berhad will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, SDS Group Berhad actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

SDS Group Berhad's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. We think that SDS Group Berhad's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for SDS Group Berhad you should be aware of, and 2 of them are a bit concerning.

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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