Here's Why Ancom Berhad (KLSE:ANCOM) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Ancom Berhad (KLSE:ANCOM) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Ancom Berhad

What Is Ancom Berhad's Debt?

The image below, which you can click on for greater detail, shows that Ancom Berhad had debt of RM300.8m at the end of May 2021, a reduction from RM322.1m over a year. However, it also had RM108.8m in cash, and so its net debt is RM192.0m.

How Strong Is Ancom Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ancom Berhad had liabilities of RM497.1m due within 12 months and liabilities of RM91.0m due beyond that. On the other hand, it had cash of RM108.8m and RM370.2m worth of receivables due within a year. So it has liabilities totalling RM109.0m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Ancom Berhad is worth RM420.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ancom Berhad's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 4.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Ancom Berhad is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 162% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Ancom Berhad's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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 last three years, Ancom Berhad actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Ancom Berhad's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its interest cover does undermine this impression a bit. Zooming out, Ancom Berhad seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Ancom Berhad you should be aware of, and 1 of them makes us a bit uncomfortable.

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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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.
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