Three-A Resources Berhad (KLSE:3A) Seems To Use Debt Quite Sensibly

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.' 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 Three-A Resources Berhad (KLSE:3A) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Three-A Resources Berhad

What Is Three-A Resources Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Three-A Resources Berhad had RM12.7m of debt in December 2020, down from RM14.5m, one year before. But it also has RM26.6m in cash to offset that, meaning it has RM13.9m net cash.

How Healthy Is Three-A Resources Berhad's Balance Sheet?

The latest balance sheet data shows that Three-A Resources Berhad had liabilities of RM44.4m due within a year, and liabilities of RM21.0m falling due after that. Offsetting these obligations, it had cash of RM26.6m as well as receivables valued at RM112.2m due within 12 months. So it actually has RM73.4m more liquid assets than total liabilities.

This surplus suggests that Three-A Resources Berhad is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Three-A Resources Berhad boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that Three-A Resources Berhad has increased its EBIT by 2.9% over twelve months, which should ease any concerns about debt repayment. 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 Three-A Resources Berhad's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Three-A Resources Berhad has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. In the last three years, Three-A Resources Berhad's free cash flow amounted to 23% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Three-A Resources Berhad has RM13.9m in net cash and a decent-looking balance sheet. And it also grew its EBIT by 2.9% over the last year. So we don't have any problem with Three-A Resources Berhad's use of debt. 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. For example Three-A Resources Berhad has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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. 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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