Here's Why SAM Engineering & Equipment (M) Berhad (KLSE:SAM) Can Manage Its Debt Responsibly

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. We note that SAM Engineering & Equipment (M) Berhad (KLSE:SAM) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.

Check out our latest analysis for SAM Engineering & Equipment (M) Berhad

What Is SAM Engineering & Equipment (M) Berhad's Debt?

The image below, which you can click on for greater detail, shows that at March 2022 SAM Engineering & Equipment (M) Berhad had debt of RM211.0m, up from RM90.3m in one year. However, because it has a cash reserve of RM31.1m, its net debt is less, at about RM180.0m.

A Look At SAM Engineering & Equipment (M) Berhad's Liabilities

The latest balance sheet data shows that SAM Engineering & Equipment (M) Berhad had liabilities of RM464.3m due within a year, and liabilities of RM48.2m falling due after that. Offsetting this, it had RM31.1m in cash and RM471.4m in receivables that were due within 12 months. So these liquid assets roughly match the total liabilities.

Having regard to SAM Engineering & Equipment (M) Berhad's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the RM1.71b company is short on cash, but still worth keeping an eye on the balance sheet.

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

SAM Engineering & Equipment (M) Berhad has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 42.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that SAM Engineering & Equipment (M) Berhad has boosted its EBIT by 30%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is SAM Engineering & Equipment (M) 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, SAM Engineering & Equipment (M) Berhad actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

The good news is that SAM Engineering & Equipment (M) Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that SAM Engineering & Equipment (M) Berhad takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 instance, we've identified 2 warning signs for SAM Engineering & Equipment (M) Berhad (1 shouldn't be ignored) you should be aware of.

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.