Is Melati Ehsan Holdings Berhad (KLSE:MELATI) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Melati Ehsan Holdings Berhad (KLSE:MELATI) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Melati Ehsan Holdings Berhad

How Much Debt Does Melati Ehsan Holdings Berhad Carry?

As you can see below, at the end of February 2023, Melati Ehsan Holdings Berhad had RM80.4m of debt, up from RM64.6m a year ago. Click the image for more detail. On the flip side, it has RM24.0m in cash leading to net debt of about RM56.4m.

How Healthy Is Melati Ehsan Holdings Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Melati Ehsan Holdings Berhad had liabilities of RM91.2m due within 12 months and liabilities of RM74.9m due beyond that. Offsetting this, it had RM24.0m in cash and RM179.9m in receivables that were due within 12 months. So it can boast RM37.7m more liquid assets than total liabilities.

This surplus strongly suggests that Melati Ehsan Holdings Berhad has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is as strong as an ox.

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).

With a debt to EBITDA ratio of 1.6, Melati Ehsan Holdings Berhad uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 10.0 times its interest expenses harmonizes with that theme. Even more impressive was the fact that Melati Ehsan Holdings Berhad grew its EBIT by 498% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is Melati Ehsan Holdings 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. Over the last three years, Melati Ehsan Holdings Berhad saw substantial negative free cash flow, in total. 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

Melati Ehsan Holdings Berhad's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Zooming out, Melati Ehsan Holdings Berhad seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Melati Ehsan Holdings Berhad (including 1 which doesn't sit too well with us) .

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.