Here's Why Summerset Group Holdings (NZSE:SUM) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Summerset Group Holdings Limited (NZSE:SUM) does use debt in its business. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Summerset Group Holdings

What Is Summerset Group Holdings's Debt?

As you can see below, at the end of June 2020, Summerset Group Holdings had NZ$688.2m of debt, up from NZ$523.2m a year ago. Click the image for more detail. However, it does have NZ$35.1m in cash offsetting this, leading to net debt of about NZ$653.2m.

How Healthy Is Summerset Group Holdings's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Summerset Group Holdings had liabilities of NZ$150.0m due within 12 months and liabilities of NZ$2.17b due beyond that. Offsetting these obligations, it had cash of NZ$35.1m as well as receivables valued at NZ$24.7m due within 12 months. So it has liabilities totalling NZ$2.26b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of NZ$2.43b. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 21.0, it's fair to say Summerset Group Holdings does have a significant amount of debt. However, its interest coverage of 2.9 is reasonably strong, which is a good sign. On a lighter note, we note that Summerset Group Holdings grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Summerset Group Holdings'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Summerset Group Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Summerset Group Holdings's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. It's also worth noting that Summerset Group Holdings is in the Healthcare industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Summerset Group Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Summerset Group Holdings is showing 4 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

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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