Here's Why DKSH Holdings (Malaysia) Berhad (KLSE:DKSH) Is Weighed Down By Its Debt Load

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. We can see that DKSH Holdings (Malaysia) Berhad (KLSE:DKSH) does use debt in its business. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for DKSH Holdings (Malaysia) Berhad

What Is DKSH Holdings (Malaysia) Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 DKSH Holdings (Malaysia) Berhad had RM567.9m of debt, an increase on RM530.1m, over one year. However, it also had RM55.4m in cash, and so its net debt is RM512.5m.

How Strong Is DKSH Holdings (Malaysia) Berhad's Balance Sheet?

According to the last reported balance sheet, DKSH Holdings (Malaysia) Berhad had liabilities of RM1.43b due within 12 months, and liabilities of RM585.7m due beyond 12 months. Offsetting these obligations, it had cash of RM55.4m as well as receivables valued at RM1.35b due within 12 months. So it has liabilities totalling RM606.2m more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's RM482.4m 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

DKSH Holdings (Malaysia) Berhad's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Investors should also be troubled by the fact that DKSH Holdings (Malaysia) Berhad saw its EBIT drop by 16% over the last twelve months. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if DKSH Holdings (Malaysia) Berhad can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, DKSH Holdings (Malaysia) Berhad reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, DKSH Holdings (Malaysia) Berhad's level of total liabilities 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 conversion of EBIT to free cash flow also fails to instill confidence. Taking into account all the aforementioned factors, it looks like DKSH Holdings (Malaysia) Berhad has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. For example - DKSH Holdings (Malaysia) Berhad has 1 warning sign we think 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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