Is Straco (SGX:S85) A Risky Investment?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Straco Corporation Limited (SGX:S85) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Straco

How Much Debt Does Straco Carry?

As you can see below, Straco had S$22.9m of debt at June 2020, down from S$31.9m a year prior. But it also has S$186.1m in cash to offset that, meaning it has S$163.2m net cash.

A Look At Straco's Liabilities

We can see from the most recent balance sheet that Straco had liabilities of S$34.6m falling due within a year, and liabilities of S$87.5m due beyond that. Offsetting these obligations, it had cash of S$186.1m as well as receivables valued at S$5.47m due within 12 months. So it actually has S$69.4m more liquid assets than total liabilities.

It's good to see that Straco has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Straco has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Straco's saving grace is its low debt levels, because its EBIT has tanked 71% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Straco 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. While Straco has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Straco produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While it is always sensible to investigate a company's debt, in this case Straco has S$163.2m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in S$7.1m. So we don't think Straco's use of debt is risky. 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. For instance, we've identified 3 warning signs for Straco (1 is a bit unpleasant) 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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