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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Southern Cross Media Group Limited (ASX:SXL) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Southern Cross Media Group's Debt?
The image below, which you can click on for greater detail, shows that Southern Cross Media Group had debt of AU$346.0m at the end of December 2018, a reduction from AU$360.5m over a year. However, because it has a cash reserve of AU$49.9m, its net debt is less, at about AU$296.1m.
How Healthy Is Southern Cross Media Group's Balance Sheet?
We can see from the most recent balance sheet that Southern Cross Media Group had liabilities of AU$85.4m falling due within a year, and liabilities of AU$708.3m due beyond that. On the other hand, it had cash of AU$49.9m and AU$124.5m worth of receivables due within a year. So its liabilities total AU$619.3m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Southern Cross Media Group has a market capitalization of AU$1.04b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 1.9, Southern Cross Media Group uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.9 times its interest expenses harmonizes with that theme. Unfortunately, Southern Cross Media Group saw its EBIT slide 4.6% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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 Southern Cross Media Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Southern Cross Media Group generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for Southern Cross Media Group was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to grow its EBIT. Considering this range of data points, we think Southern Cross Media Group is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. We'd be motivated to research the stock further if we found out that Southern Cross Media Group insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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