Is Batu Kawan Berhad (KLSE:BKAWAN) A Risky Investment?

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.' 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 Batu Kawan Berhad (KLSE:BKAWAN) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Batu Kawan Berhad

How Much Debt Does Batu Kawan Berhad Carry?

As you can see below, at the end of December 2022, Batu Kawan Berhad had RM10.7b of debt, up from RM10.2b a year ago. Click the image for more detail. However, it does have RM3.80b in cash offsetting this, leading to net debt of about RM6.91b.

How Healthy Is Batu Kawan Berhad's Balance Sheet?

According to the last reported balance sheet, Batu Kawan Berhad had liabilities of RM6.30b due within 12 months, and liabilities of RM9.55b due beyond 12 months. Offsetting this, it had RM3.80b in cash and RM3.49b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM8.56b.

This is a mountain of leverage relative to its market capitalization of RM8.58b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

Batu Kawan Berhad's net debt of 1.6 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.8 times interest expense) certainly does not do anything to dispel this impression. But the other side of the story is that Batu Kawan Berhad saw its EBIT decline by 8.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Batu Kawan 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Batu Kawan Berhad recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On the face of it, Batu Kawan Berhad's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Batu Kawan Berhad's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 3 warning signs for Batu Kawan Berhad you should be aware of.

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.