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.' 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 Rimbunan Sawit Berhad (KLSE:RSAWIT) makes use of debt. But the real question is whether this debt is making the company risky.
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Rimbunan Sawit Berhad Carry?
You can click the graphic below for the historical numbers, but it shows that Rimbunan Sawit Berhad had RM380.9m of debt in December 2021, down from RM401.7m, one year before. However, it also had RM18.5m in cash, and so its net debt is RM362.5m.
How Strong Is Rimbunan Sawit Berhad's Balance Sheet?
We can see from the most recent balance sheet that Rimbunan Sawit Berhad had liabilities of RM298.4m falling due within a year, and liabilities of RM229.1m due beyond that. On the other hand, it had cash of RM18.5m and RM24.7m worth of receivables due within a year. So its liabilities total RM484.3m more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its market capitalization of RM490.0m, so it does suggest shareholders should keep an eye on Rimbunan Sawit Berhad's use of debt. 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). 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).
Weak interest cover of 0.36 times and a disturbingly high net debt to EBITDA ratio of 5.6 hit our confidence in Rimbunan Sawit Berhad like a one-two punch to the gut. The debt burden here is substantial. However, the silver lining was that Rimbunan Sawit Berhad achieved a positive EBIT of RM4.8m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Rimbunan Sawit Berhad will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Rimbunan Sawit Berhad actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
On the face of it, Rimbunan Sawit Berhad's net debt to EBITDA left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Rimbunan Sawit Berhad stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Even though Rimbunan Sawit Berhad lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check out how earnings have been trending over the last few years.
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.
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.