Pesona Metro Holdings Berhad (KLSE:PESONA) Takes On Some Risk With Its Use Of 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Pesona Metro Holdings Berhad (KLSE:PESONA) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Pesona Metro Holdings Berhad

What Is Pesona Metro Holdings Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Pesona Metro Holdings Berhad had RM163.5m of debt in September 2022, down from RM214.6m, one year before. However, it does have RM22.7m in cash offsetting this, leading to net debt of about RM140.8m.

How Healthy Is Pesona Metro Holdings Berhad's Balance Sheet?

We can see from the most recent balance sheet that Pesona Metro Holdings Berhad had liabilities of RM265.2m falling due within a year, and liabilities of RM171.3m due beyond that. Offsetting this, it had RM22.7m in cash and RM256.5m in receivables that were due within 12 months. So its liabilities total RM157.3m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of RM208.5m, so it does suggest shareholders should keep an eye on Pesona Metro Holdings Berhad's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Pesona Metro Holdings Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (11.0), and fairly weak interest coverage, since EBIT is just 0.42 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Pesona Metro Holdings Berhad's EBIT was down 86% 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 you can't view debt in total isolation; since Pesona Metro Holdings Berhad will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Pesona Metro Holdings Berhad actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Pesona Metro Holdings Berhad's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it's fair to say that Pesona Metro Holdings Berhad 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. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Pesona Metro Holdings Berhad (of which 2 are potentially serious!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.