Is Hengyuan Refining Company Berhad (KLSE:HENGYUAN) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hengyuan Refining Company Berhad (KLSE:HENGYUAN) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Hengyuan Refining Company Berhad

How Much Debt Does Hengyuan Refining Company Berhad Carry?

As you can see below, at the end of September 2022, Hengyuan Refining Company Berhad had RM1.16b of debt, up from RM1.10b a year ago. Click the image for more detail. However, it does have RM581.1m in cash offsetting this, leading to net debt of about RM574.2m.

How Strong Is Hengyuan Refining Company Berhad's Balance Sheet?

The latest balance sheet data shows that Hengyuan Refining Company Berhad had liabilities of RM5.15b due within a year, and liabilities of RM351.7m falling due after that. On the other hand, it had cash of RM581.1m and RM1.98b worth of receivables due within a year. So its liabilities total RM2.93b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the RM1.09b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Hengyuan Refining Company Berhad would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hengyuan Refining Company Berhad's net debt is only 1.4 times its EBITDA. And its EBIT covers its interest expense a whopping 12.9 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Hengyuan Refining Company Berhad grew its EBIT by 190% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hengyuan Refining Company 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, 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, Hengyuan Refining Company Berhad actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen Hengyuan Refining Company Berhad is not finding it easy, given its level of total liabilities, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. Considering this range of data points, we think Hengyuan Refining Company Berhad is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Hengyuan Refining Company Berhad (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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.