The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Centurion Corporation Limited (SGX:OU8) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Centurion

How Much Debt Does Centurion Carry?

As you can see below, at the end of June 2019, Centurion had S$723.6m of debt, up from S$652.0m a year ago. Click the image for more detail. However, it also had S$61.4m in cash, and so its net debt is S$662.2m.

A Look At Centurion's Liabilities

We can see from the most recent balance sheet that Centurion had liabilities of S$90.0m falling due within a year, and liabilities of S$722.6m due beyond that. Offsetting these obligations, it had cash of S$61.4m as well as receivables valued at S$8.27m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$742.8m.

The deficiency here weighs heavily on the S$344.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Centurion would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a net debt to EBITDA ratio of 8.8, it's fair to say Centurion does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 2.8 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Centurion grew its EBIT at 11% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Centurion can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Centurion generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

To be frank both Centurion's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Centurion stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.