Is Reach Energy Berhad (KLSE:REACH) Using Debt In A Risky Way?

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.' 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. We note that Reach Energy Berhad (KLSE:REACH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Reach Energy Berhad

What Is Reach Energy Berhad's Debt?

As you can see below, at the end of June 2021, Reach Energy Berhad had RM696.4m of debt, up from RM661.7m a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

How Strong Is Reach Energy Berhad's Balance Sheet?

The latest balance sheet data shows that Reach Energy Berhad had liabilities of RM419.9m due within a year, and liabilities of RM426.7m falling due after that. Offsetting this, it had RM11.6m in cash and RM6.02m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM829.0m.

The deficiency here weighs heavily on the RM93.2m 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, Reach Energy Berhad would likely require a major re-capitalisation if it had to pay its creditors today. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Reach Energy 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.

In the last year Reach Energy Berhad had a loss before interest and tax, and actually shrunk its revenue by 17%, to RM94m. That's not what we would hope to see.

Caveat Emptor

Not only did Reach Energy Berhad's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost a very considerable RM173m at the EBIT level. Reflecting on this and the significant total liabilities, it's hard to know what to say about the stock because of our intense dis-affinity for it. Sure, the company might have a nice story about how they are going on to a brighter future. But the reality is that it is low on liquid assets relative to liabilities, and it lost RM90m in the last year. So we're not very excited about owning this stock. Its too risky for us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Reach Energy Berhad has 2 warning signs (and 1 which shouldn't be ignored) we think 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. 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.
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