Stock Analysis

Here's Why Engtex Group Berhad (KLSE:ENGTEX) Has A Meaningful Debt Burden

KLSE:ENGTEX
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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.' 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. As with many other companies Engtex Group Berhad (KLSE:ENGTEX) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Engtex Group Berhad

What Is Engtex Group Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that Engtex Group Berhad had debt of RM430.1m at the end of June 2020, a reduction from RM481.3m over a year. On the flip side, it has RM68.0m in cash leading to net debt of about RM362.1m.

debt-equity-history-analysis
KLSE:ENGTEX Debt to Equity History November 24th 2020

How Strong Is Engtex Group Berhad's Balance Sheet?

According to the last reported balance sheet, Engtex Group Berhad had liabilities of RM449.3m due within 12 months, and liabilities of RM69.9m due beyond 12 months. Offsetting these obligations, it had cash of RM68.0m as well as receivables valued at RM285.1m due within 12 months. So it has liabilities totalling RM166.0m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of RM207.3m, so it does suggest shareholders should keep an eye on Engtex Group Berhad's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.2 times and a disturbingly high net debt to EBITDA ratio of 7.9 hit our confidence in Engtex Group Berhad like a one-two punch to the gut. The debt burden here is substantial. Investors should also be troubled by the fact that Engtex Group Berhad saw its EBIT drop by 16% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Engtex Group Berhad's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Engtex Group Berhad produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Engtex Group Berhad's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Engtex Group Berhad's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For instance, we've identified 2 warning signs for Engtex Group Berhad (1 is a bit concerning) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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