Stock Analysis

Here's Why ACO Group Berhad (KLSE:ACO) Can Manage Its Debt Responsibly

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KLSE:ACO
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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that ACO Group Berhad (KLSE:ACO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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.

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What Is ACO Group Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of May 2021 ACO Group Berhad had RM33.3m of debt, an increase on RM26.7m, over one year. However, it does have RM26.6m in cash offsetting this, leading to net debt of about RM6.69m.

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KLSE:ACO Debt to Equity History September 28th 2021

How Strong Is ACO Group Berhad's Balance Sheet?

The latest balance sheet data shows that ACO Group Berhad had liabilities of RM56.7m due within a year, and liabilities of RM16.3m falling due after that. On the other hand, it had cash of RM26.6m and RM37.3m worth of receivables due within a year. So its liabilities total RM9.04m more than the combination of its cash and short-term receivables.

Of course, ACO Group Berhad has a market capitalization of RM110.5m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

ACO Group Berhad's net debt is only 0.68 times its EBITDA. And its EBIT easily covers its interest expense, being 10.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that ACO Group Berhad saw its EBIT decline by 8.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 ACO Group Berhad will need earnings to service that debt. 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, ACO Group Berhad created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

ACO Group Berhad's interest cover was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. When we consider all the factors mentioned above, we do feel a bit cautious about ACO Group Berhad's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 3 warning signs for ACO Group Berhad that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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