Is Kuala Lumpur Kepong Berhad (KLSE:KLK) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Kuala Lumpur Kepong Berhad (KLSE:KLK) makes use of debt. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Kuala Lumpur Kepong Berhad

What Is Kuala Lumpur Kepong Berhad's Net Debt?

As you can see below, at the end of September 2024, Kuala Lumpur Kepong Berhad had RM11.2b of debt, up from RM9.89b a year ago. Click the image for more detail. However, because it has a cash reserve of RM2.38b, its net debt is less, at about RM8.84b.

A Look At Kuala Lumpur Kepong Berhad's Liabilities

Zooming in on the latest balance sheet data, we can see that Kuala Lumpur Kepong Berhad had liabilities of RM7.01b due within 12 months and liabilities of RM8.51b due beyond that. Offsetting this, it had RM2.38b in cash and RM3.13b in receivables that were due within 12 months. So it has liabilities totalling RM10.0b more than its cash and near-term receivables, combined.

Kuala Lumpur Kepong Berhad has a market capitalization of RM22.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Kuala Lumpur Kepong Berhad has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Notably, Kuala Lumpur Kepong Berhad's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Kuala Lumpur Kepong Berhad recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Kuala Lumpur Kepong Berhad's interest cover makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its EBIT growth rate gives us reason to be optimistic. When we consider all the factors discussed, it seems to us that Kuala Lumpur Kepong Berhad is taking some risks with its use of debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Kuala Lumpur Kepong Berhad .

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.