These 4 Measures Indicate That Sephaku Holdings (JSE:SEP) Is Using Debt Reasonably Well

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Sephaku Holdings Limited (JSE:SEP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sephaku Holdings

What Is Sephaku Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Sephaku Holdings had R48.3m of debt in March 2022, down from R71.3m, one year before. However, it also had R30.8m in cash, and so its net debt is R17.5m.

A Look At Sephaku Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Sephaku Holdings had liabilities of R122.0m due within 12 months and liabilities of R132.7m due beyond that. Offsetting these obligations, it had cash of R30.8m as well as receivables valued at R89.0m due within 12 months. So it has liabilities totalling R135.0m more than its cash and near-term receivables, combined.

Sephaku Holdings has a market capitalization of R282.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Sephaku Holdings's low debt to EBITDA ratio of 0.37 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.2 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Sephaku Holdings's EBIT launched higher than Elon Musk, gaining a whopping 149% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sephaku Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, Sephaku Holdings 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.

Our View

Happily, Sephaku Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its interest cover does undermine this impression a bit. When we consider the range of factors above, it looks like Sephaku Holdings is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Sephaku Holdings (at least 1 which is potentially serious) , and understanding them should be part of your investment process.

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.