Sarawak Oil Palms Berhad (KLSE:SOP) Could Easily Take On More Debt

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. As with many other companies Sarawak Oil Palms Berhad (KLSE:SOP) makes use of debt. But the real question is whether this debt is making the company risky.

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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Sarawak Oil Palms Berhad

What Is Sarawak Oil Palms Berhad's Net Debt?

As you can see below, Sarawak Oil Palms Berhad had RM1.04b of debt at September 2021, down from RM1.15b a year prior. However, because it has a cash reserve of RM954.9m, its net debt is less, at about RM83.4m.

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

According to the last reported balance sheet, Sarawak Oil Palms Berhad had liabilities of RM1.02b due within 12 months, and liabilities of RM726.3m due beyond 12 months. Offsetting this, it had RM954.9m in cash and RM347.0m in receivables that were due within 12 months. So its liabilities total RM447.5m more than the combination of its cash and short-term receivables.

Of course, Sarawak Oil Palms Berhad has a market capitalization of RM3.07b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). 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).

Sarawak Oil Palms Berhad has a low net debt to EBITDA ratio of only 0.13. And its EBIT easily covers its interest expense, being 29.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Sarawak Oil Palms Berhad has boosted its EBIT by 40%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sarawak Oil Palms 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Sarawak Oil Palms Berhad recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Sarawak Oil Palms Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. We think Sarawak Oil Palms Berhad is no more beholden to its lenders, than the birds are to birdwatchers. To our minds it has a healthy happy balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Sarawak Oil Palms Berhad (1 is significant!) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.