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.' 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 Singapore Technologies Engineering Ltd (SGX:S63) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Singapore Technologies Engineering

What Is Singapore Technologies Engineering's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Singapore Technologies Engineering had S$6.17b of debt, an increase on S$2.03b, over one year. However, because it has a cash reserve of S$533.3m, its net debt is less, at about S$5.64b.

How Strong Is Singapore Technologies Engineering's Balance Sheet?

We can see from the most recent balance sheet that Singapore Technologies Engineering had liabilities of S$7.52b falling due within a year, and liabilities of S$4.52b due beyond that. On the other hand, it had cash of S$533.3m and S$3.23b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$8.28b.

This deficit is considerable relative to its market capitalization of S$10.5b, so it does suggest shareholders should keep an eye on Singapore Technologies Engineering's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Strangely Singapore Technologies Engineering has a sky high EBITDA ratio of 5.6, implying high debt, but a strong interest coverage of 11.3. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably Singapore Technologies Engineering's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Singapore Technologies Engineering's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Singapore Technologies Engineering generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Both Singapore Technologies Engineering's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. But truth be told its net debt to EBITDA had us nibbling our nails. Looking at all this data makes us feel a little cautious about Singapore Technologies Engineering's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Singapore Technologies Engineering that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.