Does British American Tobacco (Malaysia) Berhad (KLSE:BAT) Have A Healthy Balance Sheet?

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 British American Tobacco (Malaysia) Berhad (KLSE:BAT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for British American Tobacco (Malaysia) Berhad

What Is British American Tobacco (Malaysia) Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 British American Tobacco (Malaysia) Berhad had debt of RM510.0m, up from RM421.0m in one year. However, it does have RM29.0m in cash offsetting this, leading to net debt of about RM481.0m.

A Look At British American Tobacco (Malaysia) Berhad's Liabilities

The latest balance sheet data shows that British American Tobacco (Malaysia) Berhad had liabilities of RM752.1m due within a year, and liabilities of RM19.2m falling due after that. Offsetting these obligations, it had cash of RM29.0m as well as receivables valued at RM383.3m due within 12 months. So its liabilities total RM359.1m more than the combination of its cash and short-term receivables.

Since publicly traded British American Tobacco (Malaysia) Berhad shares are worth a total of RM3.79b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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).

British American Tobacco (Malaysia) Berhad has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 21.2 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that British American Tobacco (Malaysia) Berhad's load is not too heavy, because its EBIT was down 27% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine British American Tobacco (Malaysia) 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, British American Tobacco (Malaysia) Berhad recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Based on what we've seen British American Tobacco (Malaysia) Berhad is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to cover its interest expense with its EBIT is pretty flash. Considering this range of data points, we think British American Tobacco (Malaysia) Berhad is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with British American Tobacco (Malaysia) Berhad (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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