We Think Hap Seng Consolidated Berhad (KLSE:HAPSENG) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Hap Seng Consolidated Berhad (KLSE:HAPSENG) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Hap Seng Consolidated Berhad

What Is Hap Seng Consolidated Berhad's Net Debt?

The chart below, which you can click on for greater detail, shows that Hap Seng Consolidated Berhad had RM7.05b in debt in September 2023; about the same as the year before. On the flip side, it has RM3.78b in cash leading to net debt of about RM3.27b.

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 RM4.40b due within 12 months and liabilities of RM5.04b due beyond that. Offsetting these obligations, it had cash of RM3.78b as well as receivables valued at RM1.84b due within 12 months. So it has liabilities totalling RM3.82b more than its cash and near-term receivables, combined.

Hap Seng Consolidated Berhad has a market capitalization of RM11.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hap Seng Consolidated Berhad has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 4.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, Hap Seng Consolidated Berhad saw its EBIT tank 46% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Hap Seng Consolidated Berhad's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Hap Seng Consolidated Berhad's EBIT growth rate was disappointing. Having said that, its ability to handle its total liabilities isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Hap Seng Consolidated Berhad stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Hap Seng Consolidated Berhad (of which 1 is potentially serious!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.