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.' 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 A-Rank Berhad (KLSE:ARANK) does use debt in its business. But should shareholders be worried about its use of debt?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is A-Rank Berhad's Debt?
The image below, which you can click on for greater detail, shows that at April 2021 A-Rank Berhad had debt of RM99.7m, up from RM38.0m in one year. However, because it has a cash reserve of RM23.8m, its net debt is less, at about RM75.9m.
A Look At A-Rank Berhad's Liabilities
We can see from the most recent balance sheet that A-Rank Berhad had liabilities of RM92.3m falling due within a year, and liabilities of RM58.9m due beyond that. On the other hand, it had cash of RM23.8m and RM66.9m worth of receivables due within a year. So it has liabilities totalling RM60.4m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since A-Rank Berhad has a market capitalization of RM123.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
A-Rank Berhad's net debt is 4.8 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 1k times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. A-Rank Berhad grew its EBIT by 9.0% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is A-Rank Berhad's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, A-Rank Berhad burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither A-Rank Berhad's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think A-Rank Berhad's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 5 warning signs for A-Rank Berhad (2 make us uncomfortable!) that you should be aware of before investing here.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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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