These 4 metrics indicate that South Ocean Holdings (JSE: SOH) is using debt reasonably well
Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems like smart money knows that debt – which is usually linked to bankruptcies – is a very important factor when you assess the risk of a business. We notice that South Ocean Holdings Limited (JSE: SOH) has debt on its balance sheet. But the most important question is: what is the risk that this debt creates?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting shareholders because lenders are forcing them to raise capital at a difficult price. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest review for South Ocean Holdings
What is the debt of South Ocean Holdings?
The image below, which you can click for more details, shows South Ocean Holdings owed R43.9million at the end of December 2020, a reduction of R75.0million over one year. However, because it has a cash reserve of R21.0 million, its net debt is lower, at around R22.9 million.
How healthy is South Ocean Holdings’ balance sheet?
We can see from the most recent balance sheet that South Ocean Holdings had liabilities of Rand 136.6 million due in one year, and liabilities of Rand 59.5 million due beyond. In return, he had R21.0 million in cash and R258.5 million in receivables due within 12 months. He can therefore boast of having R83.4 million in liquid assets more than total Liabilities.
This surplus strongly suggests that South Ocean Holdings has a rock solid balance sheet (and debt is nothing to worry about). Given this fact, we believe its track record is as strong as an ox.
In order to size a company’s debt against its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest expense. (its interest coverage). The advantage of this approach is that we take into account both the absolute quantum of the debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).
While South Ocean Holdings’ low debt-to-EBITDA ratio of 0.44 suggests only a modest use of debt, the fact that EBIT only covers interest expense 3.8 times last year leaves us reflect. But the interest payments are certainly enough to make us think about how affordable his debt is. Notably, South Ocean Holdings recorded a loss in EBIT level last year, but improved this to achieve positive EBIT of Rand 35 million in the past twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But it is the earnings of South Ocean Holdings that will influence the way the balance sheet looks going forward. So when you consider debt, it’s really worth looking at the profit trend. Click here for an interactive snapshot.
But our last consideration is also important, because a company cannot pay its debt with profits on paper; he needs cash. It is therefore important to check to what extent its profit before interest and taxes (EBIT) is converted into actual free cash flow. Over the past year, South Ocean Holdings has burned a lot of money. While this may be the result of spending for growth, it makes debt much riskier.
Our point of view
South Ocean Holdings’ total liability level suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But the truth is, we are concerned about its conversion from EBIT to free cash flow. All this considered, it looks like South Ocean Holdings can comfortably manage its current debt levels. On the plus side, this leverage can increase returns for shareholders, but the potential risk of loss is greater, so it’s worth watching the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks lie on the balance sheet – far from it. For example, we have identified 3 warning signs for South Ocean Holdings that you need to be aware of.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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