Does Sarawak Oil Palms Berhad (KLSE:SOP) Have A Healthy Balance Sheet?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. We can see that Sarawak Oil Palms Berhad (KLSE:SOP) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 Sarawak Oil Palms Berhad

What Is Sarawak Oil Palms Berhad's Debt?

The image below, which you can click on for greater detail, shows that Sarawak Oil Palms Berhad had debt of RM1.15b at the end of September 2020, a reduction from RM1.25b over a year. On the flip side, it has RM916.4m in cash leading to net debt of about RM231.5m.

How Strong Is Sarawak Oil Palms Berhad's Balance Sheet?

According to the last reported balance sheet, Sarawak Oil Palms Berhad had liabilities of RM692.7m due within 12 months, and liabilities of RM1.11b due beyond 12 months. On the other hand, it had cash of RM916.4m and RM227.0m worth of receivables due within a year. So its liabilities total RM663.3m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Sarawak Oil Palms Berhad has a market capitalization of RM2.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sarawak Oil Palms Berhad has a low net debt to EBITDA ratio of only 0.46. And its EBIT covers its interest expense a whopping 13.9 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Sarawak Oil Palms Berhad grew its EBIT by 229% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sarawak Oil Palms 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Sarawak Oil Palms Berhad actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Sarawak Oil Palms Berhad's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Considering this range of factors, it seems to us that Sarawak Oil Palms Berhad is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Sarawak Oil Palms Berhad (at least 1 which is concerning) , and understanding them should be part of your investment process.

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. 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.
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