Stock Analysis

These 4 Measures Indicate That ACO Group Berhad (KLSE:ACO) Is Using Debt Extensively

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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.' 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 ACO Group Berhad (KLSE:ACO) makes use of debt. But is this debt a concern to shareholders?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for ACO Group Berhad

How Much Debt Does ACO Group Berhad Carry?

As you can see below, ACO Group Berhad had RM21.2m of debt at November 2020, down from RM23.2m a year prior. On the flip side, it has RM20.6m in cash leading to net debt of about RM569.0k.

KLSE:ACO Debt to Equity History January 29th 2021

How Strong Is ACO Group Berhad's Balance Sheet?

The latest balance sheet data shows that ACO Group Berhad had liabilities of RM53.9m due within a year, and liabilities of RM8.18m falling due after that. Offsetting these obligations, it had cash of RM20.6m as well as receivables valued at RM42.9m due within 12 months. So it can boast RM1.38m more liquid assets than total liabilities.

This state of affairs indicates that ACO Group Berhad's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the RM105.9m company is short on cash, but still worth keeping an eye on the balance sheet. But either way, ACO Group Berhad has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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.

ACO Group Berhad's net debt to EBITDA ratio is very low, at 0.075, suggesting the debt is only trivial. Although with EBIT only covering interest expenses 5.8 times over, the company is truly paying for borrowing. Shareholders should be aware that ACO Group Berhad's EBIT was down 42% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, ACO Group Berhad reported free cash flow worth 5.6% 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

ACO Group Berhad's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its net debt to EBITDA was re-invigorating. Looking at all the angles mentioned above, it does seem to us that ACO Group 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that ACO Group Berhad is showing 4 warning signs in our investment analysis , you should know about...

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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