These 4 Measures Indicate That SDS Group Berhad (KLSE:SDS) Is Using Debt Reasonably Well

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies SDS Group Berhad (KLSE:SDS) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for SDS Group Berhad

What Is SDS Group Berhad's Debt?

The image below, which you can click on for greater detail, shows that SDS Group Berhad had debt of RM26.8m at the end of December 2020, a reduction from RM29.8m over a year. However, because it has a cash reserve of RM17.1m, its net debt is less, at about RM9.69m.

How Healthy Is SDS Group Berhad's Balance Sheet?

According to the last reported balance sheet, SDS Group Berhad had liabilities of RM34.8m due within 12 months, and liabilities of RM38.2m due beyond 12 months. Offsetting this, it had RM17.1m in cash and RM13.2m in receivables that were due within 12 months. So its liabilities total RM42.6m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since SDS Group Berhad has a market capitalization of RM150.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

While SDS Group Berhad's low debt to EBITDA ratio of 0.56 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.2 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. We note that SDS Group Berhad grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. 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 SDS Group Berhad'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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, SDS Group 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.

Our View

The good news is that SDS Group Berhad's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. Zooming out, SDS Group Berhad seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that SDS Group Berhad is showing 2 warning signs in our investment analysis , you should know about...

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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