Is Chuan Huat Resources Berhad (KLSE:CHUAN) Using Too Much 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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chuan Huat Resources Berhad

What Is Chuan Huat Resources Berhad's Debt?

The image below, which you can click on for greater detail, shows that Chuan Huat Resources Berhad had debt of RM224.4m at the end of December 2020, a reduction from RM264.6m over a year. However, because it has a cash reserve of RM22.6m, its net debt is less, at about RM201.9m.

A Look At Chuan Huat Resources Berhad's Liabilities

The latest balance sheet data shows that Chuan Huat Resources Berhad had liabilities of RM248.8m due within a year, and liabilities of RM40.6m falling due after that. On the other hand, it had cash of RM22.6m and RM197.1m worth of receivables due within a year. So its liabilities total RM69.8m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of RM99.5m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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 (24.9), and fairly weak interest coverage, since EBIT is just 0.51 times the interest expense. This means we'd consider it to have a heavy debt load. Given the debt load, it's hardly ideal that Chuan Huat Resources Berhad's EBIT was pretty flat over the last twelve months. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into 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 interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Overall, it seems to us that Chuan Huat Resources Berhad's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Case in point: We've spotted 4 warning signs for Chuan Huat Resources Berhad you should be aware of, and 2 of them shouldn't be ignored.

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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