Sern Kou Resources Berhad (KLSE:SERNKOU) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, '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. Importantly, Sern Kou Resources Berhad (KLSE:SERNKOU) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Sern Kou Resources Berhad

What Is Sern Kou Resources Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that Sern Kou Resources Berhad had RM63.2m of debt in September 2020, down from RM68.3m, one year before. However, because it has a cash reserve of RM28.0m, its net debt is less, at about RM35.1m.

A Look At Sern Kou Resources Berhad's Liabilities

According to the last reported balance sheet, Sern Kou Resources Berhad had liabilities of RM74.3m due within 12 months, and liabilities of RM32.8m due beyond 12 months. Offsetting these obligations, it had cash of RM28.0m as well as receivables valued at RM96.5m due within 12 months. So it actually has RM17.4m more liquid assets than total liabilities.

This surplus suggests that Sern Kou Resources Berhad has a conservative balance sheet, and could probably eliminate its debt without much difficulty.

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).

While Sern Kou Resources Berhad's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.7 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Unfortunately, Sern Kou Resources Berhad saw its EBIT slide 2.0% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Sern Kou Resources Berhad's earnings that will influence how the balance sheet holds up in the future. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Sern Kou Resources Berhad reported free cash flow worth 14% 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

Sern Kou Resources Berhad's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that it has an adequate capacity to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Sern Kou Resources Berhad's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Sern Kou Resources Berhad 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.

If you decide to trade Sern Kou Resources Berhad, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.