Does Hap Seng Consolidated Berhad (KLSE:HAPSENG) Have A Healthy Balance Sheet?

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 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. Importantly, Hap Seng Consolidated Berhad (KLSE:HAPSENG) does carry debt. But should shareholders be worried about its use of debt?

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 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Hap Seng Consolidated Berhad

What Is Hap Seng Consolidated Berhad's Debt?

As you can see below, at the end of June 2022, Hap Seng Consolidated Berhad had RM7.09b of debt, up from RM6.55b a year ago. Click the image for more detail. However, it also had RM3.24b in cash, and so its net debt is RM3.85b.

How Strong Is Hap Seng Consolidated Berhad's Balance Sheet?

According to the last reported balance sheet, Hap Seng Consolidated Berhad had liabilities of RM4.16b due within 12 months, and liabilities of RM5.35b due beyond 12 months. Offsetting these obligations, it had cash of RM3.24b as well as receivables valued at RM2.59b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM3.68b.

Hap Seng Consolidated Berhad has a market capitalization of RM14.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hap Seng Consolidated Berhad's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 10.2 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Hap Seng Consolidated Berhad grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hap Seng Consolidated 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Hap Seng Consolidated Berhad recorded free cash flow worth 60% 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

Happily, Hap Seng Consolidated Berhad's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its interest cover is also very heartening. Taking all this data into account, it seems to us that Hap Seng Consolidated Berhad takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Hap Seng Consolidated Berhad (including 2 which are potentially serious) .

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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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.