Leong Hup International Berhad (KLSE:LHI) Use Of Debt Could Be Considered Risky

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 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. We note that Leong Hup International Berhad (KLSE:LHI) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Leong Hup International Berhad

What Is Leong Hup International Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Leong Hup International Berhad had RM2.65b of debt, an increase on RM2.30b, over one year. However, because it has a cash reserve of RM776.2m, its net debt is less, at about RM1.87b.

How Healthy Is Leong Hup International Berhad's Balance Sheet?

The latest balance sheet data shows that Leong Hup International Berhad had liabilities of RM2.53b due within a year, and liabilities of RM937.3m falling due after that. Offsetting this, it had RM776.2m in cash and RM715.8m in receivables that were due within 12 months. So its liabilities total RM1.97b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of RM2.54b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Leong Hup International Berhad's net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 2.2 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Leong Hup International Berhad's EBIT was down 42% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Leong Hup International 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Leong Hup International Berhad created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Leong Hup International Berhad's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. We're quite clear that we consider Leong Hup International Berhad to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 2 warning signs we've spotted with Leong Hup International Berhad (including 1 which makes us a bit uncomfortable) .

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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