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.' 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 Gadang Holdings Berhad (KLSE:GADANG) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Gadang Holdings Berhad's Debt?
The image below, which you can click on for greater detail, shows that at August 2020 Gadang Holdings Berhad had debt of RM365.8m, up from RM317.0m in one year. However, because it has a cash reserve of RM113.0m, its net debt is less, at about RM252.8m.
A Look At Gadang Holdings Berhad's Liabilities
According to the last reported balance sheet, Gadang Holdings Berhad had liabilities of RM523.9m due within 12 months, and liabilities of RM439.0m due beyond 12 months. Offsetting this, it had RM113.0m in cash and RM334.3m in receivables that were due within 12 months. So its liabilities total RM515.6m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the RM291.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Gadang Holdings Berhad would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Strangely Gadang Holdings Berhad has a sky high EBITDA ratio of 5.5, implying high debt, but a strong interest coverage of 1k. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Shareholders should be aware that Gadang Holdings Berhad's EBIT was down 45% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Gadang Holdings Berhad's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Gadang Holdings Berhad burned a lot of cash. 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.
To be frank both Gadang Holdings Berhad's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. After considering the datapoints discussed, we think Gadang Holdings 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. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Gadang Holdings Berhad (of which 1 is a bit concerning!) you should know about.
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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Gadang Holdings Berhad
Gadang Holdings Berhad, an investment holding company, engages in civil engineering and construction, property development, water supply, and mechanical and electrical engineering businesses in Malaysia, Indonesia, and Singapore.
Flawless balance sheet with reasonable growth potential.