ABM Fujiya Berhad (KLSE:AFUJIYA) Takes On Some Risk With Its Use Of Debt

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.' 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. We note that ABM Fujiya Berhad (KLSE:AFUJIYA) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for ABM Fujiya Berhad

What Is ABM Fujiya Berhad's Net Debt?

The chart below, which you can click on for greater detail, shows that ABM Fujiya Berhad had RM70.8m in debt in September 2021; about the same as the year before. However, because it has a cash reserve of RM12.0m, its net debt is less, at about RM58.8m.

A Look At ABM Fujiya Berhad's Liabilities

According to the last reported balance sheet, ABM Fujiya Berhad had liabilities of RM120.9m due within 12 months, and liabilities of RM7.05m due beyond 12 months. Offsetting this, it had RM12.0m in cash and RM57.6m in receivables that were due within 12 months. So its liabilities total RM58.2m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of RM68.4m, so it does suggest shareholders should keep an eye on ABM Fujiya Berhad's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.38 times and a disturbingly high net debt to EBITDA ratio of 7.2 hit our confidence in ABM Fujiya Berhad like a one-two punch to the gut. The debt burden here is substantial. Even worse, ABM Fujiya Berhad saw its EBIT tank 91% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since ABM Fujiya Berhad will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, ABM Fujiya Berhad actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, ABM Fujiya Berhad's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. 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 bigger picture, it seems clear to us that ABM Fujiya Berhad's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that ABM Fujiya Berhad is showing 2 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.