We Think Nestlé (Malaysia) Berhad (KLSE:NESTLE) Can Manage Its Debt With Ease

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 can see that Nestlé (Malaysia) Berhad (KLSE:NESTLE) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Nestlé (Malaysia) Berhad

What Is Nestlé (Malaysia) Berhad's Net Debt?

As you can see below, Nestlé (Malaysia) Berhad had RM100.0m of debt at September 2021, down from RM150.0m a year prior. However, because it has a cash reserve of RM24.8m, its net debt is less, at about RM75.2m.

How Strong Is Nestlé (Malaysia) Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Nestlé (Malaysia) Berhad had liabilities of RM1.77b due within 12 months and liabilities of RM465.1m due beyond that. Offsetting this, it had RM24.8m in cash and RM389.4m in receivables that were due within 12 months. So it has liabilities totalling RM1.82b more than its cash and near-term receivables, combined.

Since publicly traded Nestlé (Malaysia) Berhad shares are worth a total of RM31.1b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. But either way, Nestlé (Malaysia) Berhad has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With debt at a measly 0.079 times EBITDA and EBIT covering interest a whopping 25.1 times, it's clear that Nestlé (Malaysia) Berhad is not a desperate borrower. So relative to past earnings, the debt load seems trivial. Fortunately, Nestlé (Malaysia) Berhad grew its EBIT by 5.3% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Nestlé (Malaysia) 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, 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. Over the most recent three years, Nestlé (Malaysia) Berhad recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Nestlé (Malaysia) Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think Nestlé (Malaysia) Berhad's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Nestlé (Malaysia) Berhad that you should be aware of before investing here.

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.