Is Chuan Huat Resources Berhad (KLSE:CHUAN) Using Too Much Debt?

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.' 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. Importantly, Chuan Huat Resources Berhad (KLSE:CHUAN) does carry debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Chuan Huat Resources Berhad

What Is Chuan Huat Resources Berhad's Net Debt?

As you can see below, at the end of March 2022, Chuan Huat Resources Berhad had RM223.0m of debt, up from RM193.7m a year ago. Click the image for more detail. On the flip side, it has RM26.5m in cash leading to net debt of about RM196.5m.

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

Zooming in on the latest balance sheet data, we can see that Chuan Huat Resources Berhad had liabilities of RM243.0m due within 12 months and liabilities of RM37.5m due beyond that. On the other hand, it had cash of RM26.5m and RM183.5m worth of receivables due within a year. So it has liabilities totalling RM70.6m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM70.0m, 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. 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 has a rather high debt to EBITDA ratio of 7.5 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.9 times, suggesting it can responsibly service its obligations. The silver lining is that Chuan Huat Resources Berhad grew its EBIT by 148% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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.

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. Over the most recent three years, Chuan Huat Resources Berhad recorded free cash flow worth 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Chuan Huat Resources Berhad's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Chuan Huat Resources Berhad is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Chuan Huat Resources Berhad (of which 1 is concerning!) you should know about.

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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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.