Is Far East Holdings Berhad (KLSE:FAREAST) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We note that Far East Holdings Berhad (KLSE:FAREAST) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

Check out our latest analysis for Far East Holdings Berhad

What Is Far East Holdings Berhad's Debt?

As you can see below, at the end of September 2020, Far East Holdings Berhad had RM154.0m of debt, up from none a year ago. Click the image for more detail. However, because it has a cash reserve of RM52.0m, its net debt is less, at about RM102.0m.

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

According to the last reported balance sheet, Far East Holdings Berhad had liabilities of RM115.4m due within 12 months, and liabilities of RM239.0m due beyond 12 months. Offsetting this, it had RM52.0m in cash and RM112.2m in receivables that were due within 12 months. So it has liabilities totalling RM190.2m more than its cash and near-term receivables, combined.

Given Far East Holdings Berhad has a market capitalization of RM1.67b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Far East Holdings Berhad's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 428 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Far East Holdings Berhad grew its EBIT by 128% over twelve months. 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, 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. During the last three years, Far East Holdings Berhad burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Far East Holdings Berhad's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Far East Holdings Berhad can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Far East Holdings Berhad you should be aware of, and 1 of them is a bit concerning.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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