We Think Hengyuan Refining Company Berhad (KLSE:HENGYUAN) Is Taking Some Risk With Its Debt

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.' 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. As with many other companies Hengyuan Refining Company Berhad (KLSE:HENGYUAN) makes use of debt. 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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Hengyuan Refining Company Berhad

How Much Debt Does Hengyuan Refining Company Berhad Carry?

As you can see below, Hengyuan Refining Company Berhad had RM918.1m of debt at September 2020, down from RM1.24b a year prior. However, because it has a cash reserve of RM242.0m, its net debt is less, at about RM676.1m.

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

We can see from the most recent balance sheet that Hengyuan Refining Company Berhad had liabilities of RM1.64b falling due within a year, and liabilities of RM689.3m due beyond that. On the other hand, it had cash of RM242.0m and RM678.3m worth of receivables due within a year. So its liabilities total RM1.41b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of RM1.65b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hengyuan Refining Company Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (5.9), and fairly weak interest coverage, since EBIT is just 0.55 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Hengyuan Refining Company Berhad is that it turned last year's EBIT loss into a gain of RM5.5m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hengyuan Refining Company Berhad will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Hengyuan Refining Company 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.

Our View

Hengyuan Refining Company Berhad's interest cover and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Hengyuan Refining Company Berhad's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Hengyuan Refining Company Berhad (of which 1 can't be ignored!) you should know about.

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.

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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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