Chuan Huat Resources Berhad (KLSE:CHUAN) Use Of Debt Could Be Considered Risky

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.' 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 can see that Chuan Huat Resources Berhad (KLSE:CHUAN) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Chuan Huat Resources Berhad

What Is Chuan Huat Resources Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Chuan Huat Resources Berhad had debt of RM244.4m, up from RM223.0m in one year. However, it also had RM23.4m in cash, and so its net debt is RM221.0m.

A Look At Chuan Huat Resources Berhad's Liabilities

The latest balance sheet data shows that Chuan Huat Resources Berhad had liabilities of RM251.4m due within a year, and liabilities of RM60.7m falling due after that. On the other hand, it had cash of RM23.4m and RM185.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM102.9m.

When you consider that this deficiency exceeds the company's RM75.9m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Chuan Huat Resources Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (21.6), and fairly weak interest coverage, since EBIT is just 0.80 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Chuan Huat Resources Berhad's EBIT was down 74% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chuan Huat Resources 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Chuan Huat Resources Berhad created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On the face of it, Chuan Huat Resources Berhad's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its level of total liabilities also fails to instill confidence. Considering all the factors previously mentioned, we think that Chuan Huat Resources Berhad really is carrying too much debt. To us, that makes the stock rather risky, like walking through a dog park with your eyes closed. But some investors may feel differently. 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. To that end, you should learn about the 3 warning signs we've spotted with Chuan Huat Resources Berhad (including 2 which are a bit concerning) .

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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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.