These 4 Measures Indicate That Sime Darby Plantation Berhad (KLSE:SIMEPLT) Is Using Debt Reasonably Well

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Sime Darby Plantation Berhad (KLSE:SIMEPLT) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Sime Darby Plantation Berhad

What Is Sime Darby Plantation Berhad's Net Debt?

As you can see below, Sime Darby Plantation Berhad had RM6.10b of debt at March 2023, down from RM6.54b a year prior. However, because it has a cash reserve of RM884.0m, its net debt is less, at about RM5.22b.

A Look At Sime Darby Plantation Berhad's Liabilities

Zooming in on the latest balance sheet data, we can see that Sime Darby Plantation Berhad had liabilities of RM5.89b due within 12 months and liabilities of RM7.04b due beyond that. Offsetting these obligations, it had cash of RM884.0m as well as receivables valued at RM2.55b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM9.50b.

Sime Darby Plantation Berhad has a market capitalization of RM29.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Sime Darby Plantation Berhad has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 15.4 times over. So we're pretty relaxed about its super-conservative use of debt. It is just as well that Sime Darby Plantation Berhad's load is not too heavy, because its EBIT was down 39% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Sime Darby Plantation 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 company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Sime Darby Plantation Berhad recorded free cash flow worth 66% 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

Based on what we've seen Sime Darby Plantation Berhad is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about Sime Darby Plantation Berhad's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Sime Darby Plantation Berhad you should know about.

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.

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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.