We Think SMRT Holdings Berhad (KLSE:SMRT) Is Taking Some Risk With Its Debt

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that SMRT Holdings Berhad (KLSE:SMRT) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

Our analysis indicates that SMRT is potentially undervalued!

What Is SMRT Holdings Berhad's Debt?

The image below, which you can click on for greater detail, shows that SMRT Holdings Berhad had debt of RM17.4m at the end of June 2022, a reduction from RM27.9m over a year. But on the other hand it also has RM42.1m in cash, leading to a RM24.7m net cash position.

How Strong Is SMRT Holdings Berhad's Balance Sheet?

The latest balance sheet data shows that SMRT Holdings Berhad had liabilities of RM75.5m due within a year, and liabilities of RM187.9m falling due after that. Offsetting these obligations, it had cash of RM42.1m as well as receivables valued at RM48.6m due within 12 months. So it has liabilities totalling RM172.8m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the RM46.8m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, SMRT Holdings Berhad would probably need a major re-capitalization if its creditors were to demand repayment. Given that SMRT Holdings Berhad has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.

We note that SMRT Holdings Berhad grew its EBIT by 20% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is SMRT Holdings 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While SMRT Holdings Berhad has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last two years, SMRT Holdings Berhad actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

Although SMRT Holdings Berhad's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of RM24.7m. The cherry on top was that in converted 135% of that EBIT to free cash flow, bringing in RM54m. So although we see some areas for improvement, we're not too worried about SMRT Holdings Berhad's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for SMRT Holdings Berhad (1 is a bit concerning) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.