David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Sembcorp Industries Ltd (SGX:U96) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Sembcorp Industries

How Much Debt Does Sembcorp Industries Carry?

As you can see below, Sembcorp Industries had S$7.46b of debt at June 2023, down from S$8.67b a year prior. However, it also had S$1.03b in cash, and so its net debt is S$6.43b.

A Look At Sembcorp Industries' Liabilities

The latest balance sheet data shows that Sembcorp Industries had liabilities of S$3.54b due within a year, and liabilities of S$7.16b falling due after that. Offsetting this, it had S$1.03b in cash and S$1.63b in receivables that were due within 12 months. So its liabilities total S$8.04b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of S$8.99b. 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 has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The silver lining is that Sembcorp Industries grew its EBIT by 147% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. The balance sheet is clearly the area to focus on when you are analysing debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 100% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Sembcorp Industries's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Sembcorp Industries is in the Integrated Utilities industry, which is often considered to be quite defensive. Considering this range of data points, we think Sembcorp Industries is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 Sembcorp Industries (at least 1 which is concerning) , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.