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.' 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. Importantly, SBS Transit Ltd (SGX:S61) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for SBS Transit
What Is SBS Transit's Debt?
As you can see below, SBS Transit had S$25.0m of debt at December 2020, down from S$75.0m a year prior. But it also has S$85.6m in cash to offset that, meaning it has S$60.6m net cash.
How Healthy Is SBS Transit's Balance Sheet?
According to the last reported balance sheet, SBS Transit had liabilities of S$386.8m due within 12 months, and liabilities of S$166.0m due beyond 12 months. Offsetting these obligations, it had cash of S$85.6m as well as receivables valued at S$290.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$177.2m.
Given SBS Transit has a market capitalization of S$954.3m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, SBS Transit boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for SBS Transit if management cannot prevent a repeat of the 23% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if SBS Transit can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While SBS Transit 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. Over the last three years, SBS Transit 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.
Summing up
While SBS Transit does have more liabilities than liquid assets, it also has net cash of S$60.6m. The cherry on top was that in converted 114% of that EBIT to free cash flow, bringing in S$133m. So we are not troubled with SBS Transit's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that SBS Transit is showing 1 warning sign in our investment analysis , you should know about...
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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About SGX:S61
SBS Transit
Provides bus and rail public transport services primarily in Singapore.
Flawless balance sheet and fair value.
