Hap Seng Consolidated Berhad (KLSE:HAPSENG) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Hap Seng Consolidated Berhad (KLSE:HAPSENG) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Hap Seng Consolidated Berhad

What Is Hap Seng Consolidated Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Hap Seng Consolidated Berhad had RM6.93b of debt, an increase on RM6.17b, over one year. However, it does have RM3.50b in cash offsetting this, leading to net debt of about RM3.43b.

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

Zooming in on the latest balance sheet data, we can see that Hap Seng Consolidated Berhad had liabilities of RM4.68b due within 12 months and liabilities of RM4.39b due beyond that. On the other hand, it had cash of RM3.50b and RM2.66b worth of receivables due within a year. So it has liabilities totalling RM2.91b more than its cash and near-term receivables, combined.

Of course, Hap Seng Consolidated Berhad has a market capitalization of RM20.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

Hap Seng Consolidated Berhad's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 4.0 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. However, one redeeming factor is that Hap Seng Consolidated Berhad grew its EBIT at 18% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hap Seng Consolidated Berhad's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Considering the last three years, Hap Seng Consolidated Berhad actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Hap Seng Consolidated Berhad's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. Looking at all the angles mentioned above, it does seem to us that Hap Seng Consolidated Berhad is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 3 warning signs for Hap Seng Consolidated Berhad (1 shouldn't be ignored) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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