Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that Southern Steel Berhad (KLSE: SSTEEL) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Southern Steel Berhad
How much debt does Southern Steel Berhad have?
The graph below, which you can click on for more details, shows that Southern Steel Berhad had a debt of RM847.6 million in March 2022; about the same as the previous year. On the other hand, he has RM110.3 million in cash, resulting in a net debt of around RM737.3 million.
How strong is Southern Steel Berhad’s balance sheet?
We can see from the most recent balance sheet that Southern Steel Berhad had liabilities of RM1.15 billion due in one year and liabilities of RM341.6 million due beyond. In return, he had RM110.3 million in cash and RM165.0 million in receivables due within 12 months. Thus, its liabilities total RM1.21 billion more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on society itself, like a child struggling under the weight of a huge backpack full of books, his sports gear and a trumpet. So we definitely think shareholders need to watch this one closely. Ultimately, Southern Steel Berhad would likely need a major recapitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Southern Steel Berhad’s debt is 4.4 times its EBITDA, and its EBIT covers its interest expense 5.2 times. This suggests that while debt levels are significant, we will refrain from labeling them problematic. Notably, Southern Steel Berhad’s EBIT launched higher than Elon Musk, gaining a whopping 768% from a year ago. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t look at debt in total isolation; since Southern Steel Berhad will need revenue to repay this debt. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past two years, Southern Steel Berhad has produced strong free cash flow equivalent to 53% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Reflecting on Southern Steel Berhad’s attempt to rein in its total liabilities, we are certainly not enthusiastic. But on the bright side, its EBIT growth rate is a good sign and makes us more optimistic. Looking at the balance sheet and taking all of these factors into account, we think the debt makes Southern Steel Berhad’s stock a bit risky. This isn’t necessarily a bad thing, but we would generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example, Southern Steel Berhad has 2 warning signs (and 1 of concern) that we think you should know about.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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