Chuan Huat Resources Berhad (KLSE:CHUAN) Has No Shortage Of Debt

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 Chuan Huat Resources Berhad (KLSE:CHUAN) 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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Chuan Huat Resources Berhad

What Is Chuan Huat Resources Berhad's Net Debt?

As you can see below, Chuan Huat Resources Berhad had RM262.4m of debt at September 2024, down from RM279.0m a year prior. On the flip side, it has RM35.5m in cash leading to net debt of about RM226.9m.

How Strong Is Chuan Huat Resources Berhad's Balance Sheet?

The latest balance sheet data shows that Chuan Huat Resources Berhad had liabilities of RM276.5m due within a year, and liabilities of RM54.8m falling due after that. On the other hand, it had cash of RM35.5m and RM201.3m worth of receivables due within a year. So it has liabilities totalling RM94.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM65.8m, we think shareholders really should watch Chuan Huat Resources Berhad's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Chuan Huat Resources Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (21.5), and fairly weak interest coverage, since EBIT is just 0.47 times the interest expense. The debt burden here is substantial. Worse, Chuan Huat Resources Berhad's EBIT was down 25% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But it is Chuan Huat Resources 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Chuan Huat Resources Berhad saw substantial negative free cash flow, in total. 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.

Our View

To be frank both Chuan Huat Resources Berhad's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its net debt to EBITDA fails to inspire much confidence. It looks to us like Chuan Huat Resources Berhad carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Chuan Huat Resources Berhad (3 don't sit too well with us) 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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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.