Is Sembcorp Industries (SGX:U96) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Sembcorp Industries Ltd (SGX:U96) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sembcorp Industries

How Much Debt Does Sembcorp Industries Carry?

As you can see below, Sembcorp Industries had S$7.43b of debt at December 2021, down from S$7.81b a year prior. However, it does have S$1.45b in cash offsetting this, leading to net debt of about S$5.98b.

A Look At Sembcorp Industries' Liabilities

Zooming in on the latest balance sheet data, we can see that Sembcorp Industries had liabilities of S$2.91b due within 12 months and liabilities of S$7.57b due beyond that. On the other hand, it had cash of S$1.45b and S$1.75b worth of receivables due within a year. So it has liabilities totalling S$7.28b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of S$5.30b, we think shareholders really should watch Sembcorp Industries's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Sembcorp Industries's debt to EBITDA ratio (4.9) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Sembcorp Industries grew its EBIT a smooth 34% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sembcorp Industries 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sembcorp Industries produced sturdy free cash flow equating to 51% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Sembcorp Industries's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Integrated Utilities industry companies like Sembcorp Industries commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Sembcorp Industries's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Sembcorp Industries is showing 3 warning signs in our investment analysis , and 1 of those is significant...

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. 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.