Stock Analysis

These 4 Measures Indicate That MCE Holdings Berhad (KLSE:MCEHLDG) Is Using Debt Reasonably Well

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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies MCE Holdings Berhad (KLSE:MCEHLDG) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

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What Is MCE Holdings Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of October 2022 MCE Holdings Berhad had RM20.4m of debt, an increase on RM19.0m, over one year. On the flip side, it has RM7.65m in cash leading to net debt of about RM12.7m.

KLSE:MCEHLDG Debt to Equity History March 18th 2023

How Healthy Is MCE Holdings Berhad's Balance Sheet?

We can see from the most recent balance sheet that MCE Holdings Berhad had liabilities of RM35.5m falling due within a year, and liabilities of RM14.1m due beyond that. Offsetting these obligations, it had cash of RM7.65m as well as receivables valued at RM26.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM15.4m.

Since publicly traded MCE Holdings Berhad shares are worth a total of RM104.5m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

MCE Holdings Berhad's net debt is only 0.62 times its EBITDA. And its EBIT covers its interest expense a whopping 16.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, MCE Holdings Berhad turned things around in the last 12 months, delivering and EBIT of RM16m. There's no doubt that we learn most about debt from the balance sheet. But it is MCE Holdings Berhad's earnings that will influence how the balance sheet holds up in the future. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, MCE Holdings Berhad reported free cash flow worth 2.6% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis MCE Holdings Berhad's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. When we consider all the elements mentioned above, it seems to us that MCE Holdings Berhad is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with MCE Holdings Berhad , and understanding them should be part of your investment process.

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.

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