Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Melewar Industrial Group Berhad (KLSE:MELEWAR) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Melewar Industrial Group Berhad's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Melewar Industrial Group Berhad had debt of RM102.7m, up from RM86.1m in one year. But it also has RM117.4m in cash to offset that, meaning it has RM14.7m net cash.
How Healthy Is Melewar Industrial Group Berhad's Balance Sheet?
The latest balance sheet data shows that Melewar Industrial Group Berhad had liabilities of RM268.2m due within a year, and liabilities of RM90.3m falling due after that. On the other hand, it had cash of RM117.4m and RM78.2m worth of receivables due within a year. So its liabilities total RM163.0m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the RM82.7m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Melewar Industrial Group Berhad would likely require a major re-capitalisation if it had to pay its creditors today. Melewar Industrial Group Berhad boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
The good news is that Melewar Industrial Group Berhad has increased its EBIT by 6.2% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Melewar Industrial Group 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. While Melewar Industrial Group Berhad has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent two years, Melewar Industrial Group Berhad recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Although Melewar Industrial Group Berhad's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of RM14.7m. On top of that, it increased its EBIT by 6.2% in the last twelve months. Despite its cash we think that Melewar Industrial Group Berhad seems to struggle to handle its total liabilities, so we are wary of the stock. 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. For example, we've discovered 2 warning signs for Melewar Industrial Group Berhad (1 is a bit unpleasant!) that you should be aware of before investing here.
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. 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.