Is Emico Holdings Berhad (KLSE:EMICO) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 Emico Holdings Berhad (KLSE:EMICO) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Emico Holdings Berhad

What Is Emico Holdings Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Emico Holdings Berhad had debt of RM7.41m, up from RM6.60m in one year. On the flip side, it has RM1.73m in cash leading to net debt of about RM5.68m.

A Look At Emico Holdings Berhad's Liabilities

We can see from the most recent balance sheet that Emico Holdings Berhad had liabilities of RM13.7m falling due within a year, and liabilities of RM8.64m due beyond that. Offsetting this, it had RM1.73m in cash and RM11.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM9.53m.

This deficit isn't so bad because Emico Holdings Berhad is worth RM34.5m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Emico Holdings Berhad has a low net debt to EBITDA ratio of only 0.87. And its EBIT covers its interest expense a whopping 17.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The modesty of its debt load may become crucial for Emico Holdings Berhad if management cannot prevent a repeat of the 51% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Emico Holdings Berhad will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Emico Holdings Berhad reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Emico Holdings Berhad's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Emico Holdings Berhad's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with Emico Holdings Berhad (at least 2 which shouldn't be ignored) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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This article by Simply Wall St is general in nature. 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.
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