Is LB Aluminium Berhad (KLSE:LBALUM) A Risky Investment?

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 note that LB Aluminium Berhad (KLSE:LBALUM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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 LB Aluminium Berhad

How Much Debt Does LB Aluminium Berhad Carry?

The image below, which you can click on for greater detail, shows that at July 2021 LB Aluminium Berhad had debt of RM215.4m, up from RM168.3m in one year. On the flip side, it has RM39.3m in cash leading to net debt of about RM176.1m.

A Look At LB Aluminium Berhad's Liabilities

According to the last reported balance sheet, LB Aluminium Berhad had liabilities of RM285.5m due within 12 months, and liabilities of RM69.3m due beyond 12 months. Offsetting this, it had RM39.3m in cash and RM103.7m in receivables that were due within 12 months. So its liabilities total RM211.8m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of RM182.6m, we think shareholders really should watch LB Aluminium Berhad's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt to EBITDA of 3.5 LB Aluminium Berhad has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.6 times its interest expense, and its net debt to EBITDA, was quite high, at 3.5. Notably, LB Aluminium Berhad's EBIT launched higher than Elon Musk, gaining a whopping 515% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since LB Aluminium Berhad will need earnings to service that debt. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, LB Aluminium Berhad saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

We'd go so far as to say LB Aluminium Berhad's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making LB Aluminium Berhad stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 4 warning signs for LB Aluminium Berhad you should be aware of, and 1 of them is a bit unpleasant.

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.

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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