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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Kuala Lumpur Kepong Berhad (KLSE:KLK) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

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What Is Kuala Lumpur Kepong Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Kuala Lumpur Kepong Berhad had RM9.38b of debt, an increase on RM8.77b, over one year. However, because it has a cash reserve of RM2.79b, its net debt is less, at about RM6.60b.

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

Zooming in on the latest balance sheet data, we can see that Kuala Lumpur Kepong Berhad had liabilities of RM5.15b due within 12 months and liabilities of RM9.04b due beyond that. Offsetting these obligations, it had cash of RM2.79b as well as receivables valued at RM2.87b due within 12 months. So it has liabilities totalling RM8.53b more than its cash and near-term receivables, combined.

Kuala Lumpur Kepong Berhad has a market capitalization of RM22.4b, so it could very likely raise cash to ameliorate 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.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

With a debt to EBITDA ratio of 1.5, Kuala Lumpur Kepong Berhad uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.5 times its interest expenses harmonizes with that theme. Also good is that Kuala Lumpur Kepong Berhad grew its EBIT at 14% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Kuala Lumpur Kepong 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. In the last three years, Kuala Lumpur Kepong Berhad's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Kuala Lumpur Kepong Berhad's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its conversion of EBIT to free cash flow somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Kuala Lumpur Kepong 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. 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. We've identified 3 warning signs with Kuala Lumpur Kepong Berhad (at least 1 which is concerning) , and understanding them should be part of your investment process.

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. 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.