Kuala Lumpur Kepong Berhad (KLSE:KLK) Takes On Some Risk With Its Use Of 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.' 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. We note that Kuala Lumpur Kepong Berhad (KLSE:KLK) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 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.

View our latest analysis for Kuala Lumpur Kepong Berhad

What Is Kuala Lumpur Kepong Berhad's Debt?

As you can see below, at the end of June 2024, Kuala Lumpur Kepong Berhad had RM11.2b of debt, up from RM9.37b a year ago. Click the image for more detail. On the flip side, it has RM2.56b in cash leading to net debt of about RM8.63b.

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

The latest balance sheet data shows that Kuala Lumpur Kepong Berhad had liabilities of RM6.14b due within a year, and liabilities of RM9.55b falling due after that. Offsetting these obligations, it had cash of RM2.56b as well as receivables valued at RM3.71b due within 12 months. So its liabilities total RM9.42b more than the combination of its cash and short-term receivables.

Kuala Lumpur Kepong Berhad has a market capitalization of RM23.5b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

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. Even worse, Kuala Lumpur Kepong Berhad saw its EBIT tank 21% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 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 always check how much of that EBIT is translated into 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 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 level of total liabilities is not so bad. Overall, we think it's fair to say that Kuala Lumpur Kepong Berhad has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Kuala Lumpur Kepong Berhad is showing 3 warning signs in our investment analysis , and 2 of those are potentially serious...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.