Here's Why Favelle Favco Berhad (KLSE:FAVCO) Can Manage Its Debt Responsibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Favelle Favco Berhad (KLSE:FAVCO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Favelle Favco Berhad

How Much Debt Does Favelle Favco Berhad Carry?

As you can see below, Favelle Favco Berhad had RM53.3m of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have RM309.3m in cash offsetting this, leading to net cash of RM255.9m.

How Healthy Is Favelle Favco Berhad's Balance Sheet?

The latest balance sheet data shows that Favelle Favco Berhad had liabilities of RM526.9m due within a year, and liabilities of RM66.8m falling due after that. Offsetting these obligations, it had cash of RM309.3m as well as receivables valued at RM355.3m due within 12 months. So it actually has RM70.9m more liquid assets than total liabilities.

This short term liquidity is a sign that Favelle Favco Berhad could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Favelle Favco Berhad boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Favelle Favco Berhad's saving grace is its low debt levels, because its EBIT has tanked 64% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. 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 Favelle Favco Berhad can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Favelle Favco Berhad may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Favelle Favco Berhad created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Favelle Favco Berhad has net cash of RM255.9m, as well as more liquid assets than liabilities. So we don't have any problem with Favelle Favco Berhad's use of debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Favelle Favco Berhad 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. 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.
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