Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, SMIS Corporation Berhad (KLSE:SMISCOR) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is SMIS Corporation Berhad's Debt?
The chart below, which you can click on for greater detail, shows that SMIS Corporation Berhad had RM13.6m in debt in March 2021; about the same as the year before. However, it does have RM10.00m in cash offsetting this, leading to net debt of about RM3.56m.
How Healthy Is SMIS Corporation Berhad's Balance Sheet?
According to the last reported balance sheet, SMIS Corporation Berhad had liabilities of RM34.3m due within 12 months, and liabilities of RM5.08m due beyond 12 months. On the other hand, it had cash of RM10.00m and RM30.3m worth of receivables due within a year. So it actually has RM868.0k more liquid assets than total liabilities.
This state of affairs indicates that SMIS Corporation Berhad's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the RM44.7m company is struggling for cash, we still think it's worth monitoring its balance sheet.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
SMIS Corporation Berhad has a very low debt to EBITDA ratio of 0.46 so it is strange to see weak interest coverage, with last year's EBIT being only 1.6 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Notably, SMIS Corporation Berhad made a loss at the EBIT level, last year, but improved that to positive EBIT of RM982k in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is SMIS Corporation Berhad's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, SMIS Corporation Berhad burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
While SMIS Corporation Berhad's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But at least its net debt to EBITDA is a gleaming silver lining to those clouds. Looking at all the angles mentioned above, it does seem to us that SMIS Corporation Berhad is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for SMIS Corporation Berhad (1 is a bit unpleasant) you should be aware of.
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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