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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.’ 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 Sunex S.A. (WSE:SNX) does use debt in its business. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
How Much Debt Does Sunex Carry?
The image below, which you can click on for greater detail, shows that at March 2019 Sunex had debt of zł3.88m, up from zł2.53m in one year. However, it does have zł750.0k in cash offsetting this, leading to net debt of about zł3.13m.
How Strong Is Sunex’s Balance Sheet?
According to the last reported balance sheet, Sunex had liabilities of zł22.2m due within 12 months, and liabilities of zł7.54m due beyond 12 months. On the other hand, it had cash of zł750.0k and zł14.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by zł14.7m.
This is a mountain of leverage relative to its market capitalization of zł23.4m. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Sunex does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
Sunex’s net debt is only 0.57 times its EBITDA. And its EBIT easily covers its interest expense, being 12.2 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Sunex grew its EBIT by 131% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Sunex will need earnings to service that debt. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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. During the last three years, Sunex burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Based on what we’ve seen Sunex is not finding it easy conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. There’s no doubt that its ability to cover its interest expense with its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Sunex’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you’re interested in Sunex, you may well want to click here to check an interactive graph of its earnings per share history.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.