Is S P Setia Berhad (KLSE:SPSETIA) A Risky Investment?

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. As with many other companies S P Setia Berhad (KLSE:SPSETIA) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for S P Setia Berhad

What Is S P Setia Berhad's Net Debt?

The chart below, which you can click on for greater detail, shows that S P Setia Berhad had RM12.5b in debt in September 2022; about the same as the year before. However, it also had RM2.54b in cash, and so its net debt is RM10.0b.

A Look At S P Setia Berhad's Liabilities

The latest balance sheet data shows that S P Setia Berhad had liabilities of RM7.86b due within a year, and liabilities of RM7.48b falling due after that. Offsetting this, it had RM2.54b in cash and RM2.65b in receivables that were due within 12 months. So its liabilities total RM10.2b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the RM2.57b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, S P Setia Berhad would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

S P Setia Berhad has a rather high debt to EBITDA ratio of 17.0 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. The good news is that S P Setia Berhad improved its EBIT by 6.2% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if S P Setia Berhad can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, S P Setia 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

To be frank both S P Setia Berhad's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow 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 S P Setia Berhad stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 instance, we've identified 1 warning sign for S P Setia Berhad that you should be aware of.

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.