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Sims (ASX:SGM) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Sims Limited (ASX:SGM) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sims

How Much Debt Does Sims Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Sims had AU$232.0m of debt, an increase on AU$116.9m, over one year. However, its balance sheet shows it holds AU$254.1m in cash, so it actually has AU$22.1m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

How Healthy Is Sims' Balance Sheet?

We can see from the most recent balance sheet that Sims had liabilities of AU$850.7m falling due within a year, and liabilities of AU$778.0m due beyond that. Offsetting these obligations, it had cash of AU$254.1m as well as receivables valued at AU$574.5m due within 12 months. So its liabilities total AU$800.1m more than the combination of its cash and short-term receivables.

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This deficit isn't so bad because Sims is worth AU$2.91b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Sims also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Sims turned things around in the last 12 months, delivering and EBIT of AU$111m. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sims's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Sims has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Considering the last year, Sims actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing up

Although Sims's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$22.1m. So we are not troubled with Sims's debt use. 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. For instance, we've identified 2 warning signs for Sims (1 is a bit concerning) you should be aware of.

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.

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.

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