Is Muhibbah Engineering (M) Bhd (KLSE:MUHIBAH) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Muhibbah Engineering (M) Bhd. (KLSE:MUHIBAH) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. 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.

View 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 Muhibbah Engineering (M) Bhd had RM750.4m of debt in September 2022, down from RM970.1m, one year before. On the flip side, it has RM237.1m in cash leading to net debt of about RM513.3m.

A Look At Muhibbah Engineering (M) Bhd's Liabilities

According to the last reported balance sheet, Muhibbah Engineering (M) Bhd had liabilities of RM1.20b due within 12 months, and liabilities of RM214.7m due beyond 12 months. Offsetting these obligations, it had cash of RM237.1m as well as receivables valued at RM711.0m due within 12 months. So its liabilities total RM470.0m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of RM518.5m, so it does suggest shareholders should keep an eye on Muhibbah Engineering (M) Bhd's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).

Muhibbah Engineering (M) Bhd has a rather high debt to EBITDA ratio of 5.2 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. One redeeming factor for Muhibbah Engineering (M) Bhd is that it turned last year's EBIT loss into a gain of RM30m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Muhibbah Engineering (M) Bhd actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Muhibbah Engineering (M) Bhd's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Muhibbah Engineering (M) Bhd is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 1 warning sign for Muhibbah Engineering (M) Bhd that 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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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.