Here's Why Far East Holdings Berhad (KLSE:FAREAST) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Far East Holdings Berhad (KLSE:FAREAST) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Far East Holdings Berhad

How Much Debt Does Far East Holdings Berhad Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Far East Holdings Berhad had debt of RM146.3m, up from none in one year. However, because it has a cash reserve of RM79.1m, its net debt is less, at about RM67.2m.

How Healthy Is Far East Holdings Berhad's Balance Sheet?

The latest balance sheet data shows that Far East Holdings Berhad had liabilities of RM70.7m due within a year, and liabilities of RM218.2m falling due after that. Offsetting these obligations, it had cash of RM79.1m as well as receivables valued at RM73.1m due within 12 months. So its liabilities total RM136.8m more than the combination of its cash and short-term receivables.

Since publicly traded Far East Holdings Berhad shares are worth a total of RM1.69b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Far East Holdings Berhad has a low net debt to EBITDA ratio of only 0.62. And its EBIT covers its interest expense a whopping 51.9 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Far East Holdings Berhad grew its EBIT by 129% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Far East Holdings Berhad's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Far East Holdings Berhad actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

The good news is that Far East Holdings Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Taking all this data into account, it seems to us that Far East Holdings Berhad takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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 Far East Holdings Berhad has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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. 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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