These 4 Measures Indicate That HSS Engineers Berhad (KLSE:HSSEB) Is Using Debt Reasonably Well

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 HSS Engineers Berhad (KLSE:HSSEB) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.

See our latest analysis for HSS Engineers Berhad

What Is HSS Engineers Berhad's Net Debt?

As you can see below, HSS Engineers Berhad had RM68.7m of debt at September 2020, down from RM85.0m a year prior. However, it does have RM35.5m in cash offsetting this, leading to net debt of about RM33.2m.

A Look At HSS Engineers Berhad's Liabilities

We can see from the most recent balance sheet that HSS Engineers Berhad had liabilities of RM66.7m falling due within a year, and liabilities of RM59.6m due beyond that. On the other hand, it had cash of RM35.5m and RM121.1m worth of receivables due within a year. So it can boast RM30.2m more liquid assets than total liabilities.

This surplus suggests that HSS Engineers Berhad has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

While HSS Engineers Berhad's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.8 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Pleasingly, HSS Engineers Berhad is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 143% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if HSS Engineers Berhad can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, HSS Engineers Berhad produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that HSS Engineers Berhad's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And its conversion of EBIT to free cash flow is good too. Looking at the bigger picture, we think HSS Engineers Berhad's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Take risks, for example - HSS Engineers Berhad has 2 warning signs we think you should be aware of.

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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