Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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 SIIC Environment Holdings Ltd. (SGX:BHK) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for SIIC Environment Holdings
What Is SIIC Environment Holdings’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 SIIC Environment Holdings had CN¥15.0b of debt, an increase on CN¥13.6b, over one year. However, it also had CN¥2.32b in cash, and so its net debt is CN¥12.7b.
How Healthy Is SIIC Environment Holdings’ Balance Sheet?
The latest balance sheet data shows that SIIC Environment Holdings had liabilities of CN¥9.98b due within a year, and liabilities of CN¥11.4b falling due after that. On the other hand, it had cash of CN¥2.32b and CN¥3.31b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥15.7b.
The deficiency here weighs heavily on the CN¥2.32b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. At the end of the day, SIIC Environment Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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).
SIIC Environment Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (7.0), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. This means we’d consider it to have a heavy debt load. However, one redeeming factor is that SIIC Environment Holdings grew its EBIT at 13% over the last 12 months, boosting its ability to handle its debt. 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 SIIC Environment Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, SIIC Environment Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both SIIC Environment Holdings’s conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We should also note that Water Utilities industry companies like SIIC Environment Holdings commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like SIIC Environment Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. 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. We’ve identified 2 warning signs with SIIC Environment Holdings (at least 1 which is potentially serious) , and understanding them should be part of your investment process.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you decide to trade SIIC Environment Holdings, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
😄 thank you so much for this awesome website me and my sept admired this satisfied and insight
thank you so much for this impressive internet site me and my class loved this content and brainstorm