Is Southern Steel Berhad (KLSE:SSTEEL) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Southern Steel Berhad (KLSE:SSTEEL) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Southern Steel Berhad

How Much Debt Does Southern Steel Berhad Carry?

The chart below, which you can click on for greater detail, shows that Southern Steel Berhad had RM847.6m in debt in March 2022; about the same as the year before. On the flip side, it has RM110.3m in cash leading to net debt of about RM737.3m.

How Strong Is Southern Steel Berhad's Balance Sheet?

We can see from the most recent balance sheet that Southern Steel Berhad had liabilities of RM1.15b falling due within a year, and liabilities of RM341.6m due beyond that. Offsetting this, it had RM110.3m in cash and RM165.0m in receivables that were due within 12 months. So its liabilities total RM1.21b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the RM423.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Southern Steel Berhad would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

Southern Steel Berhad's debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 5.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Southern Steel Berhad's EBIT launched higher than Elon Musk, gaining a whopping 768% on last year. 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 Southern Steel 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Southern Steel Berhad produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Southern Steel Berhad's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Southern Steel Berhad stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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 Southern Steel Berhad has 2 warning signs (and 1 which is concerning) we think you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.