We Think Melati Ehsan Holdings Berhad (KLSE:MELATI) Is Taking Some Risk With Its Debt

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. We note that Melati Ehsan Holdings Berhad (KLSE:MELATI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Melati Ehsan Holdings Berhad

What Is Melati Ehsan Holdings Berhad's Debt?

As you can see below, Melati Ehsan Holdings Berhad had RM73.1m of debt at February 2024, down from RM80.4m a year prior. However, because it has a cash reserve of RM32.3m, its net debt is less, at about RM40.8m.

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 RM91.3m due within 12 months and liabilities of RM41.7m due beyond that. Offsetting these obligations, it had cash of RM32.3m as well as receivables valued at RM138.8m due within 12 months. So it actually has RM38.1m more liquid assets than total liabilities.

This surplus liquidity suggests that Melati Ehsan Holdings Berhad's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master.

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

Strangely Melati Ehsan Holdings Berhad has a sky high EBITDA ratio of 7.6, implying high debt, but a strong interest coverage of 16.9. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Melati Ehsan Holdings Berhad's EBIT fell a jaw-dropping 86% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. 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 always check how much of that EBIT is translated into free cash flow. During the last three years, Melati Ehsan Holdings 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

While Melati Ehsan Holdings Berhad's EBIT growth rate has us nervous. To wit both its interest cover and level of total liabilities were encouraging signs. Looking at all the angles mentioned above, it does seem to us that Melati Ehsan Holdings Berhad is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Melati Ehsan Holdings Berhad (1 can't be ignored!) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com