These 4 Measures Indicate That Hengyuan Refining Company Berhad (KLSE:HENGYUAN) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Hengyuan Refining Company Berhad (KLSE:HENGYUAN) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Hengyuan Refining Company Berhad

What Is Hengyuan Refining Company Berhad's Debt?

The image below, which you can click on for greater detail, shows that Hengyuan Refining Company Berhad had debt of RM815.7m at the end of December 2020, a reduction from RM1.39b over a year. However, because it has a cash reserve of RM737.2m, its net debt is less, at about RM78.5m.

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

The latest balance sheet data shows that Hengyuan Refining Company Berhad had liabilities of RM1.63b due within a year, and liabilities of RM695.6m falling due after that. Offsetting these obligations, it had cash of RM737.2m as well as receivables valued at RM544.8m due within 12 months. So its liabilities total RM1.05b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of RM1.62b, so it does suggest shareholders should keep an eye on Hengyuan Refining Company Berhad's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hengyuan Refining Company Berhad has a low net debt to EBITDA ratio of only 0.21. And its EBIT easily covers its interest expense, being 11.9 times the size. So we're pretty relaxed about its super-conservative use of debt. Better yet, Hengyuan Refining Company Berhad grew its EBIT by 571% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Hengyuan Refining Company 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Hengyuan Refining Company Berhad actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Hengyuan Refining Company Berhad's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Zooming out, Hengyuan Refining Company Berhad seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Hengyuan Refining Company Berhad you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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