Is Leader Steel Holdings Berhad (KLSE:LSTEEL) 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. Importantly, Leader Steel Holdings Berhad (KLSE:LSTEEL) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Leader Steel Holdings Berhad

How Much Debt Does Leader Steel Holdings Berhad Carry?

The image below, which you can click on for greater detail, shows that Leader Steel Holdings Berhad had debt of RM89.7m at the end of September 2020, a reduction from RM100.5m over a year. However, it does have RM17.3m in cash offsetting this, leading to net debt of about RM72.4m.

How Strong Is Leader Steel Holdings Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Leader Steel Holdings Berhad had liabilities of RM102.3m due within 12 months and liabilities of RM16.9m due beyond that. On the other hand, it had cash of RM17.3m and RM36.1m worth of receivables due within a year. So it has liabilities totalling RM65.7m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of RM78.2m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Weak interest cover of 0.60 times and a disturbingly high net debt to EBITDA ratio of 12.0 hit our confidence in Leader Steel Holdings Berhad like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that Leader Steel Holdings Berhad achieved a positive EBIT of RM2.2m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Leader Steel Holdings 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Leader Steel Holdings Berhad actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither Leader Steel Holdings Berhad's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Leader Steel Holdings Berhad is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Leader Steel Holdings Berhad (of which 1 shouldn't be ignored!) you should know about.

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. 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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