Here's Why Guan Chong Berhad (KLSE:GCB) Has A Meaningful Debt Burden

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. As with many other companies Guan Chong Berhad (KLSE:GCB) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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 Guan Chong Berhad

What Is Guan Chong Berhad's Net Debt?

As you can see below, at the end of September 2020, Guan Chong Berhad had RM1.06b of debt, up from RM934.2m a year ago. Click the image for more detail. However, it does have RM47.9m in cash offsetting this, leading to net debt of about RM1.01b.

How Healthy Is Guan Chong Berhad's Balance Sheet?

According to the last reported balance sheet, Guan Chong Berhad had liabilities of RM1.39b due within 12 months, and liabilities of RM185.9m due beyond 12 months. Offsetting these obligations, it had cash of RM47.9m as well as receivables valued at RM524.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM1.00b.

This deficit isn't so bad because Guan Chong Berhad is worth RM2.97b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Guan Chong Berhad has net debt to EBITDA of 3.6 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.6. We saw Guan Chong Berhad grow its EBIT by 3.6% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Guan Chong Berhad can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Guan Chong 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

Guan Chong Berhad's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. Taking the abovementioned factors together we do think Guan Chong Berhad's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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, we've discovered 4 warning signs for Guan Chong Berhad (1 is concerning!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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