Here's Why Straits Trading (SGX:S20) Can Manage Its Debt Responsibly

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 note that The Straits Trading Company Limited (SGX:S20) does have debt on its balance sheet. 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. 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. 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.

View our latest analysis for Straits Trading

What Is Straits Trading's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Straits Trading had S$1.27b of debt, an increase on S$1.16b, over one year. However, it does have S$404.6m in cash offsetting this, leading to net debt of about S$869.4m.

How Strong Is Straits Trading's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Straits Trading had liabilities of S$665.3m due within 12 months and liabilities of S$825.4m due beyond that. Offsetting these obligations, it had cash of S$404.6m as well as receivables valued at S$98.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$987.6m.

This deficit is considerable relative to its market capitalization of S$1.42b, so it does suggest shareholders should keep an eye on Straits Trading's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Straits Trading has a low net debt to EBITDA ratio of only 1.1. And its EBIT easily covers its interest expense, being 28.2 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Straits Trading grew its EBIT by 806% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Straits Trading 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Straits Trading reported free cash flow worth 3.7% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Straits Trading's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Straits Trading's debt levels. 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. 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 2 warning signs for Straits Trading (1 is a bit concerning) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.