Is Sime Darby Berhad (KLSE:SIME) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 can see that Sime Darby Berhad (KLSE:SIME) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Sime Darby Berhad

What Is Sime Darby Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2021 Sime Darby Berhad had RM2.22b of debt, an increase on RM1.33b, over one year. However, it does have RM2.05b in cash offsetting this, leading to net debt of about RM164.0m.

How Strong Is Sime Darby Berhad's Balance Sheet?

The latest balance sheet data shows that Sime Darby Berhad had liabilities of RM9.88b due within a year, and liabilities of RM2.70b falling due after that. Offsetting these obligations, it had cash of RM2.05b as well as receivables valued at RM4.76b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM5.77b.

Sime Darby Berhad has a market capitalization of RM16.7b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. But either way, Sime Darby Berhad has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

Sime Darby Berhad has barely any net debt, as demonstrated by its net debt to EBITDA ratio of only 0.07. Humorously, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. And we also note warmly that Sime Darby Berhad grew its EBIT by 17% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sime Darby Berhad'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, Sime Darby 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

The good news is that Sime Darby Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Sime Darby Berhad's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. Be aware that Sime Darby Berhad is showing 1 warning sign in our investment analysis , you should know about...

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.