Ho Hup Construction Company Berhad (KLSE:HOHUP) Has A Somewhat Strained Balance Sheet

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.' 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. We can see that Ho Hup Construction Company Berhad (KLSE:HOHUP) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Ho Hup Construction Company Berhad

What Is Ho Hup Construction Company Berhad's Net Debt?

As you can see below, Ho Hup Construction Company Berhad had RM455.5m of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has RM86.6m in cash leading to net debt of about RM369.0m.

How Healthy Is Ho Hup Construction Company Berhad's Balance Sheet?

We can see from the most recent balance sheet that Ho Hup Construction Company Berhad had liabilities of RM680.1m falling due within a year, and liabilities of RM227.2m due beyond that. Offsetting these obligations, it had cash of RM86.6m as well as receivables valued at RM509.7m due within 12 months. So its liabilities total RM311.0m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the RM193.8m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Ho Hup Construction Company Berhad would probably need a major re-capitalization if its creditors were to demand repayment.

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).

With a debt to EBITDA ratio of 2.3, Ho Hup Construction Company Berhad uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.6 times its interest expenses harmonizes with that theme. Importantly, Ho Hup Construction Company Berhad grew its EBIT by 72% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Ho Hup Construction Company 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Ho Hup Construction Company Berhad burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Ho Hup Construction Company Berhad's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Ho Hup Construction Company Berhad's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Ho Hup Construction Company Berhad (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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