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. Importantly, Unimech Group Berhad (KLSE:UNIMECH) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Unimech Group Berhad's Debt?
The chart below, which you can click on for greater detail, shows that Unimech Group Berhad had RM102.8m in debt in September 2020; about the same as the year before. However, because it has a cash reserve of RM40.3m, its net debt is less, at about RM62.5m.
How Strong Is Unimech Group Berhad's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Unimech Group Berhad had liabilities of RM137.0m due within 12 months and liabilities of RM24.0m due beyond that. Offsetting this, it had RM40.3m in cash and RM98.7m in receivables that were due within 12 months. So it has liabilities totalling RM22.1m more than its cash and near-term receivables, combined.
Given Unimech Group Berhad has a market capitalization of RM200.3m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). 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).
Looking at its net debt to EBITDA of 1.3 and interest cover of 4.8 times, it seems to us that Unimech Group Berhad is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unimech Group Berhad grew its EBIT by 2.0% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Unimech Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Unimech Group Berhad produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On this analysis, Unimech Group Berhad's conversion of EBIT to free cash flow was a real positive, just like an unsolicited gift of cupcakes from a work colleague. And its net debt to EBITDA should also leave shareholders feeling frolicsome. All these things considered, it appears that Unimech Group Berhad can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Take risks, for example - Unimech Group Berhad has 2 warning signs we think you should be aware of.
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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