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 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 Batu Kawan Berhad (KLSE:BKAWAN) does use debt in its business. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Batu Kawan Berhad
What Is Batu Kawan Berhad's Net Debt?
The chart below, which you can click on for greater detail, shows that Batu Kawan Berhad had RM7.18b in debt in December 2020; about the same as the year before. However, it does have RM4.48b in cash offsetting this, leading to net debt of about RM2.71b.
A Look At Batu Kawan Berhad's Liabilities
According to the last reported balance sheet, Batu Kawan Berhad had liabilities of RM3.67b due within 12 months, and liabilities of RM6.94b due beyond 12 months. On the other hand, it had cash of RM4.48b and RM2.50b worth of receivables due within a year. So it has liabilities totalling RM3.64b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Batu Kawan Berhad has a market capitalization of RM7.58b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Batu Kawan Berhad's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. In addition to that, we're happy to report that Batu Kawan Berhad has boosted its EBIT by 45%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Batu Kawan Berhad recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Batu Kawan Berhad's EBIT growth rate 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 level of total liabilities does undermine this impression a bit. All these things considered, it appears that Batu Kawan Berhad can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Be aware that Batu Kawan Berhad is showing 3 warning signs in our investment analysis , and 1 of those is concerning...
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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About KLSE:BKAWAN
Batu Kawan Berhad
An investment holding company, cultivates and processes palm and rubber products.
Mediocre balance sheet second-rate dividend payer.