We Think Serial System (SGX:S69) Can Stay On Top Of Its Debt

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.' 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 Serial System Ltd (SGX:S69) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Serial System

What Is Serial System's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Serial System had debt of US$135.2m, up from US$126.6m in one year. However, it also had US$80.6m in cash, and so its net debt is US$54.5m.

A Look At Serial System's Liabilities

Zooming in on the latest balance sheet data, we can see that Serial System had liabilities of US$234.0m due within 12 months and liabilities of US$11.0m due beyond that. Offsetting this, it had US$80.6m in cash and US$146.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$17.7m.

While this might seem like a lot, it is not so bad since Serial System has a market capitalization of US$59.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Serial System shareholders face the double whammy of a high net debt to EBITDA ratio (11.6), and fairly weak interest coverage, since EBIT is just 0.36 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Serial System achieved a positive EBIT of US$947k in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Serial System's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Serial System actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Serial System's interest cover was a real negative on this analysis, as was its net debt to EBITDA. But its conversion of EBIT to free cash flow was significantly redeeming. Looking at all this data makes us feel a little cautious about Serial System'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for Serial System (2 are a bit concerning!) that you should be aware of before investing here.

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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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. 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.
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