Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that Oceanus Group Limited (SGX:579) has a debt on its balance sheet. But the more important question is: what risk does this debt create?
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, many companies use debt to finance their growth, without any negative consequences. When we look at debt levels, we first consider cash and debt levels, together.
Discover our latest analysis for Oceanus Group
What is the net debt of the Oceanus group?
You can click on the graph below for historical figures, but it shows that in December 2021, Oceanus Group had debt of S$81.4 million, an increase from S$21.3 million, over a year. On the other hand, he has S$38.9 million in cash, resulting in a net debt of around S$42.4 million.
How healthy is the Oceanus group’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Oceanus Group had liabilities of S$95.4 million due within 12 months and liabilities of S$15.4 million due beyond. As compensation for these obligations, it had cash of S$38.9 million as well as receivables valued at S$46.5 million maturing within 12 months. It therefore has liabilities totaling S$25.3 million more than its cash and short-term receivables, combined.
Given that Oceanus Group has a market capitalization of S$460.2 million, it’s hard to believe that these liabilities pose a big threat. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
The Oceanus Group has a fairly high debt to EBITDA ratio of 6.0, which suggests significant leverage. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. Notably, Oceanus Group’s EBIT has remained fairly stable over the past year, which is not ideal given the leverage. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in total isolation; since Oceanus Group will need revenue to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We therefore always check how much of this EBIT is converted into free cash flow. Over the past two years, Oceanus Group has experienced substantial negative free cash flow, in total. While investors no doubt expect a reversal of this situation in due course, this clearly means that its use of debt is more risky.
Our point of view
To be frank, Oceanus Group’s net debt to EBITDA ratio and history of converting EBIT to free cash flow makes us rather uncomfortable with its debt levels. But at least he’s decent enough to stay above his total liabilities; it’s encouraging. Once we consider all of the above factors together, it seems to us that Oceanus Group’s debt makes it a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 5 warning signs for Oceanus Group (2 of which make us uncomfortable!) that you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.