Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Sembcorp Industries Ltd (SGX:U96) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Sembcorp Industries's Net Debt?

As you can see below, at the end of June 2024, Sembcorp Industries had S$8.36b of debt, up from S$7.46b a year ago. Click the image for more detail. However, it also had S$1.21b in cash, and so its net debt is S$7.14b.

SGX:U96 Debt to Equity History November 24th 2024

How Strong Is Sembcorp Industries' Balance Sheet?

According to the last reported balance sheet, Sembcorp Industries had liabilities of S$2.95b due within 12 months, and liabilities of S$9.33b due beyond 12 months. On the other hand, it had cash of S$1.21b and S$1.99b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$9.09b.

This deficit is considerable relative to its market capitalization of S$9.36b, so it does suggest shareholders should keep an eye on Sembcorp Industries' 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.

Sembcorp Industries's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 3.2 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. More concerning, Sembcorp Industries saw its EBIT drop by 8.3% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sembcorp Industries'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Sembcorp Industries generated free cash flow amounting to a very robust 82% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Sembcorp Industries's net debt to EBITDA and level of total liabilities definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We should also note that Integrated Utilities industry companies like Sembcorp Industries commonly do use debt without problems. Taking the abovementioned factors together we do think Sembcorp Industries's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.

At the end of the day, it's often better to focus on companies that are free from net debt.