Is Velesto Energy Berhad (KLSE:VELESTO) A Risky Investment?

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. As with many other companies Velesto Energy Berhad (KLSE:VELESTO) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

See our latest analysis for Velesto Energy Berhad

What Is Velesto Energy Berhad's Debt?

As you can see below, Velesto Energy Berhad had RM575.7m of debt at September 2021, down from RM1.19b a year prior. However, it does have RM263.0m in cash offsetting this, leading to net debt of about RM312.7m.

How Strong Is Velesto Energy Berhad's Balance Sheet?

According to the last reported balance sheet, Velesto Energy Berhad had liabilities of RM291.1m due within 12 months, and liabilities of RM438.2m due beyond 12 months. Offsetting this, it had RM263.0m in cash and RM184.6m in receivables that were due within 12 months. So its liabilities total RM281.7m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Velesto Energy Berhad has a market capitalization of RM1.11b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt sitting at just 0.55 times EBITDA, Velesto Energy Berhad is arguably pretty conservatively geared. And it boasts interest cover of 9.7 times, which is more than adequate. Better yet, Velesto Energy Berhad grew its EBIT by 381% 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 it is future earnings, more than anything, that will determine Velesto Energy Berhad's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Velesto Energy Berhad recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Velesto Energy Berhad's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. When we consider the range of factors above, it looks like Velesto Energy Berhad is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. While Velesto Energy Berhad didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.