Does Muhibbah Engineering (M) Bhd (KLSE:MUHIBAH) Have A Healthy Balance Sheet?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Muhibbah Engineering (M) Bhd. (KLSE:MUHIBAH) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Muhibbah Engineering (M) Bhd

What Is Muhibbah Engineering (M) Bhd's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Muhibbah Engineering (M) Bhd had RM896.9m of debt, an increase on RM715.3m, over one year. However, it does have RM588.2m in cash offsetting this, leading to net debt of about RM308.7m.

How Healthy Is Muhibbah Engineering (M) Bhd's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Muhibbah Engineering (M) Bhd had liabilities of RM1.46b due within 12 months and liabilities of RM273.5m due beyond that. Offsetting these obligations, it had cash of RM588.2m as well as receivables valued at RM611.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM538.0m.

Given this deficit is actually higher than the company's market capitalization of RM488.5m, we think shareholders really should watch Muhibbah Engineering (M) Bhd's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Muhibbah Engineering (M) Bhd's debt to EBITDA ratio (3.8) suggests that it uses some debt, its interest cover is very weak, at 2.0, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Muhibbah Engineering (M) Bhd's EBIT was down 57% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Muhibbah Engineering (M) Bhd's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Muhibbah Engineering (M) Bhd actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, Muhibbah Engineering (M) Bhd's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, we think it's fair to say that Muhibbah Engineering (M) Bhd has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Over time, share prices tend to follow earnings per share, so if you're interested in Muhibbah Engineering (M) Bhd, you may well want to click here to check an interactive graph of its earnings per share history.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.