Is Kuala Lumpur Kepong Berhad (KLSE:KLK) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Kuala Lumpur Kepong Berhad (KLSE:KLK) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Kuala Lumpur Kepong Berhad

How Much Debt Does Kuala Lumpur Kepong Berhad Carry?

As you can see below, at the end of March 2022, Kuala Lumpur Kepong Berhad had RM11.0b of debt, up from RM6.70b a year ago. Click the image for more detail. However, it also had RM2.82b in cash, and so its net debt is RM8.20b.

How Strong Is Kuala Lumpur Kepong Berhad's Balance Sheet?

We can see from the most recent balance sheet that Kuala Lumpur Kepong Berhad had liabilities of RM6.42b falling due within a year, and liabilities of RM9.11b due beyond that. On the other hand, it had cash of RM2.82b and RM3.17b worth of receivables due within a year. So it has liabilities totalling RM9.54b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Kuala Lumpur Kepong Berhad has a market capitalization of RM23.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

Kuala Lumpur Kepong Berhad's net debt to EBITDA ratio of about 1.9 suggests only moderate use of debt. And its strong interest cover of 13.1 times, makes us even more comfortable. It is well worth noting that Kuala Lumpur Kepong Berhad's EBIT shot up like bamboo after rain, gaining 68% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Kuala Lumpur Kepong 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Kuala Lumpur Kepong Berhad recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

The good news is that Kuala Lumpur Kepong Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that Kuala Lumpur Kepong Berhad can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Kuala Lumpur Kepong Berhad (2 don't sit too well with us) you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.