Is Sun-Sea Construction (GTSM:5516) 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.' 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. As with many other companies Sun-Sea Construction Corporation (GTSM:5516) makes use of debt. But the more important question is: how much risk is that debt creating?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Sun-Sea Construction

What Is Sun-Sea Construction's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sun-Sea Construction had NT$650.5m of debt, an increase on NT$538.3m, over one year. However, it also had NT$202.2m in cash, and so its net debt is NT$448.3m.

A Look At Sun-Sea Construction's Liabilities

We can see from the most recent balance sheet that Sun-Sea Construction had liabilities of NT$1.12b falling due within a year, and liabilities of NT$21.5m due beyond that. Offsetting these obligations, it had cash of NT$202.2m as well as receivables valued at NT$977.3m due within 12 months. So it actually has NT$41.1m more liquid assets than total liabilities.

This surplus suggests that Sun-Sea Construction has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Sun-Sea Construction has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. However, its interest coverage of 5.3 is reasonably strong, which is a good sign. We saw Sun-Sea Construction grow its EBIT by 5.5% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Sun-Sea Construction will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Sun-Sea Construction saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Sun-Sea Construction's net debt to EBITDA makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at staying on top of its total liabilities. Looking at all the angles mentioned above, it does seem to us that Sun-Sea Construction is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 Sun-Sea Construction is showing 5 warning signs in our investment analysis , and 2 of those make us uncomfortable...

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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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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