Is ACO Group Berhad (KLSE:ACO) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 ACO Group Berhad (KLSE:ACO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for ACO Group Berhad

What Is ACO Group Berhad's Debt?

The image below, which you can click on for greater detail, shows that ACO Group Berhad had debt of RM21.6m at the end of February 2024, a reduction from RM25.2m over a year. However, it also had RM18.0m in cash, and so its net debt is RM3.53m.

How Healthy Is ACO Group Berhad's Balance Sheet?

We can see from the most recent balance sheet that ACO Group Berhad had liabilities of RM55.1m falling due within a year, and liabilities of RM10.8m due beyond that. On the other hand, it had cash of RM18.0m and RM37.6m worth of receivables due within a year. So its liabilities total RM10.2m more than the combination of its cash and short-term receivables.

Since publicly traded ACO Group Berhad shares are worth a total of RM88.6m, it seems unlikely that this level of liabilities would be a major threat. 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). 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 net debt sitting at just 0.52 times EBITDA, ACO Group Berhad is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.9 times the interest expense over the last year. Also good is that ACO Group Berhad grew its EBIT at 11% over the last year, further increasing its ability to manage debt. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. In the last three years, ACO Group Berhad created free cash flow amounting to 8.8% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis ACO Group Berhad's net debt to EBITDA should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that ACO Group 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example ACO Group Berhad has 3 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

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.