Kuala Lumpur Kepong Berhad (KLSE:KLK) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, '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 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Kuala Lumpur Kepong Berhad

How Much Debt Does Kuala Lumpur Kepong Berhad Carry?

You can click the graphic below for the historical numbers, but it shows that Kuala Lumpur Kepong Berhad had RM9.37b of debt in June 2023, down from RM10.6b, one year before. However, it also had RM2.78b in cash, and so its net debt is RM6.59b.

A Look At Kuala Lumpur Kepong Berhad's Liabilities

The latest balance sheet data shows that Kuala Lumpur Kepong Berhad had liabilities of RM4.84b due within a year, and liabilities of RM8.96b falling due after that. On the other hand, it had cash of RM2.78b and RM3.27b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM7.75b.

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 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's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 5.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, Kuala Lumpur Kepong Berhad's EBIT fell a jaw-dropping 37% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Kuala Lumpur Kepong Berhad's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Kuala Lumpur Kepong Berhad's EBIT growth rate was disappointing. But at least its interest cover is not so bad. Once we consider all the factors above, together, it seems to us that Kuala Lumpur Kepong Berhad's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 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.