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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.' 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 can see that S.A.S. Dragon Holdings Limited (HKG:1184) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
Check out our latest analysis for S.A.S. Dragon Holdings
How Much Debt Does S.A.S. Dragon Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that S.A.S. Dragon Holdings had HK$2.63b of debt in June 2019, down from HK$3.59b, one year before. However, it also had HK$1.02b in cash, and so its net debt is HK$1.60b.
How Strong Is S.A.S. Dragon Holdings's Balance Sheet?
According to the last reported balance sheet, S.A.S. Dragon Holdings had liabilities of HK$3.52b due within 12 months, and liabilities of HK$351.2m due beyond 12 months. Offsetting these obligations, it had cash of HK$1.02b as well as receivables valued at HK$2.10b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$738.6m.
This deficit isn't so bad because S.A.S. Dragon Holdings is worth HK$1.45b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).