Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. Like many other companies Sasol Limited (JSE:SOL) uses debt. But does this debt worry shareholders?
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Sasol
What is Sasol’s debt?
The image below, which you can click on for more details, shows Sasol had R110.9 billion in debt at the end of December 2021, a reduction from R128.1 billion year-on-year. On the other hand, he has R30.8 billion in cash, resulting in a net debt of around R80.2 billion.
How healthy is Sasol’s balance sheet?
The latest balance sheet data shows that Sasol had liabilities of R80.4 billion due within a year, and liabilities of R141.2 billion falling due thereafter. In compensation for these obligations, it had cash of 30.8 billion rand as well as receivables valued at 33.5 billion rand due within 12 months. Thus, its liabilities total R157.4 billion more than the combination of its cash and short-term receivables.
That’s a mountain of leverage even compared to its gargantuan market cap of R223.2b. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Sasol has net debt worth 1.9x EBITDA, which isn’t too much, but its interest coverage looks a little low, with EBIT at just 5.4x interest expense. . While these numbers don’t alarm us, it’s worth noting that the company’s cost of debt has a real impact. It should be noted that Sasol’s EBIT jumped like bamboo after rain, gaining 64% over the last twelve months. This will make it easier to manage your debt. 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 Sasol can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Sasol has recorded free cash flow of 18% of its EBIT, which is really quite low. For us, such a low cash conversion creates a bit of paranoia about the ability to extinguish the debt.
Our point of view
In terms of the balance sheet, the most notable positive for Sasol is the fact that it appears capable of growing its EBIT with confidence. However, our other observations were not so encouraging. For example, its EBIT to free cash flow conversion makes us a bit nervous about its debt. Looking at all this data, we feel a bit cautious about Sasol’s debt levels. While debt has its upside in higher potential returns, we think shareholders should certainly consider how debt levels might make the stock more risky. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example – Sasol has 4 warning signs we think you should know.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Comments are closed.