Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that The Sage plc Group (LON: SGE) has debt on its balance sheet. But the most important question is: what risk does this debt create?
When is Debt a Problem?
Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first look at cash and debt levels, together.
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How much debt does Sage Group have?
The image below, which you can click for more details, shows that Sage Group was in debt of £ 714.0million at the end of September 2021, a reduction from £ 877.0million sterling over one year. However, he has £ 553.0million in cash offsetting this, leading to net debt of around £ 161.0million.
A look at the liabilities of Sage Group
Zooming in on the latest balance sheet data, we can see that Sage Group had a liability of £ 1.38bn due within 12 months and a liability of £ 838.0m beyond. In return, he had £ 553.0 million in cash and £ 248.0 million in receivables due within 12 months. Its liabilities therefore total £ 1.42 billion more than the combination of its cash and short-term receivables.
Considering that Sage Group shares listed on the stock exchange are worth a very impressive total of £ 8.59 billion, it seems unlikely that this level of liabilities will be a major threat. Having said that, it is clear that we must continue to monitor his record lest it get worse.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Sage Group has a low net debt to EBITDA ratio of just 0.33. And its EBIT covers its interest costs 17.4 times more. We could therefore say that he is no more threatened by his debt than an elephant is by a mouse. But the bad news is that Sage Group has seen its EBIT drop 13% over the past twelve months. We believe that type of performance, if repeated frequently, could well cause difficulties for the title. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Sage Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free Analyst Profit Forecast report interesting.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, Sage Group has generated strong free cash flow equivalent to 79% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that Sage Group’s demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. But the hard truth is that we are concerned about its growth rate of EBIT. When we consider the range of factors above, it seems that Sage Group is pretty reasonable with its use of debt. While this carries some risk, it can also improve returns for shareholders. Of course, we wouldn’t say no to the extra confidence we would gain if we knew that Sage Group insiders are buying stocks: if you’re on the same page, you can find out if any insiders are buying by clicking this. link link.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash net growth stocks today.
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