These 4 Measures Indicate That Sarawak Oil Palms Berhad (KLSE:SOP) Is Using Debt Safely

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Sarawak Oil Palms Berhad (KLSE:SOP) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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?

As you can see below, Sarawak Oil Palms Berhad had RM1.11b of debt at December 2020, down from RM1.22b a year prior. However, because it has a cash reserve of RM947.1m, its net debt is less, at about RM158.7m.

A Look At Sarawak Oil Palms Berhad's Liabilities

Zooming in on the latest balance sheet data, we can see that Sarawak Oil Palms Berhad had liabilities of RM655.3m due within 12 months and liabilities of RM1.10b due beyond that. On the other hand, it had cash of RM947.1m and RM220.5m worth of receivables due within a year. So it has liabilities totalling RM589.2m more than its cash and near-term receivables, combined.

Sarawak Oil Palms Berhad has a market capitalization of RM2.27b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Sarawak Oil Palms Berhad's net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 16.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Sarawak Oil Palms Berhad grew its EBIT by 106% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. The balance sheet is clearly the area to focus on when you are analysing debt. 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 we always check how much of that EBIT is translated into 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 conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

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! Overall, we don't think Sarawak Oil Palms Berhad is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. 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. For instance, we've identified 2 warning signs for Sarawak Oil Palms Berhad (1 is concerning) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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