We Think Sakura DevelopmentLtd (TPE:2539) Is Taking Some Risk With Its Debt

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 Sakura Development Co.,Ltd (TPE:2539) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sakura DevelopmentLtd

How Much Debt Does Sakura DevelopmentLtd Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sakura DevelopmentLtd had NT$8.25b of debt, an increase on NT$6.76b, over one year. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Sakura DevelopmentLtd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sakura DevelopmentLtd had liabilities of NT$7.30b due within 12 months and liabilities of NT$3.27b due beyond that. Offsetting these obligations, it had cash of NT$148.3m as well as receivables valued at NT$25.6m due within 12 months. So it has liabilities totalling NT$10.4b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of NT$17.1b, so it does suggest shareholders should keep an eye on Sakura DevelopmentLtd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

As it happens Sakura DevelopmentLtd has a fairly concerning net debt to EBITDA ratio of 5.4 but very strong interest coverage of 94.1. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Importantly, Sakura DevelopmentLtd grew its EBIT by 61% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Sakura DevelopmentLtd 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sakura DevelopmentLtd burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

While Sakura DevelopmentLtd's conversion of EBIT to free cash flow has us nervous. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Sakura DevelopmentLtd is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 2 warning signs for Sakura DevelopmentLtd (1 is 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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