Ho Hup Construction Company Berhad (KLSE:HOHUP) Has No Shortage Of 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. We note that Ho Hup Construction Company Berhad (KLSE:HOHUP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Ho Hup Construction Company Berhad

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

The chart below, which you can click on for greater detail, shows that Ho Hup Construction Company Berhad had RM626.8m in debt in June 2023; about the same as the year before. However, it also had RM36.2m in cash, and so its net debt is RM590.7m.

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

According to the last reported balance sheet, Ho Hup Construction Company Berhad had liabilities of RM734.7m due within 12 months, and liabilities of RM382.1m due beyond 12 months. On the other hand, it had cash of RM36.2m and RM502.0m worth of receivables due within a year. So its liabilities total RM578.6m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the RM146.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Ho Hup Construction Company Berhad would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.0 times and a disturbingly high net debt to EBITDA ratio of 10.7 hit our confidence in Ho Hup Construction Company Berhad like a one-two punch to the gut. The debt burden here is substantial. The good news is that Ho Hup Construction Company Berhad improved its EBIT by 7.6% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ho Hup Construction Company 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Ho Hup Construction Company Berhad burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Ho Hup Construction Company Berhad's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think Ho Hup Construction Company Berhad has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For example, we've discovered 4 warning signs for Ho Hup Construction Company Berhad (2 are a bit unpleasant!) that you should be aware of before investing here.

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. 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.