Is Hap Seng Consolidated Berhad (KLSE:HAPSENG) Using Too Much Debt?

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. Importantly, Hap Seng Consolidated Berhad (KLSE:HAPSENG) does carry 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hap Seng Consolidated Berhad

What Is Hap Seng Consolidated Berhad's Net Debt?

As you can see below, at the end of September 2022, Hap Seng Consolidated Berhad had RM6.87b of debt, up from RM6.13b a year ago. Click the image for more detail. However, it does have RM3.01b in cash offsetting this, leading to net debt of about RM3.86b.

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

We can see from the most recent balance sheet that Hap Seng Consolidated Berhad had liabilities of RM4.04b falling due within a year, and liabilities of RM5.24b due beyond that. Offsetting these obligations, it had cash of RM3.01b as well as receivables valued at RM3.22b due within 12 months. So its liabilities total RM3.05b more than the combination of its cash and short-term receivables.

Since publicly traded Hap Seng Consolidated Berhad shares are worth a total of RM16.7b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). 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 has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.2 times its interest expense, and its net debt to EBITDA, was quite high, at 2.6. Unfortunately, Hap Seng Consolidated Berhad saw its EBIT slide 9.7% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Hap Seng Consolidated Berhad recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Hap Seng Consolidated Berhad's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its interest cover is relatively strong. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Hap Seng Consolidated Berhad (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

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. 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.