Melewar Industrial Group Berhad (KLSE:MELEWAR) Has A Somewhat Strained Balance Sheet

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Melewar Industrial Group Berhad (KLSE:MELEWAR) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Melewar Industrial Group Berhad

How Much Debt Does Melewar Industrial Group Berhad Carry?

As you can see below, Melewar Industrial Group Berhad had RM116.8m of debt at September 2022, down from RM180.3m a year prior. However, it does have RM57.8m in cash offsetting this, leading to net debt of about RM59.0m.

How Healthy Is Melewar Industrial Group Berhad's Balance Sheet?

According to the last reported balance sheet, Melewar Industrial Group Berhad had liabilities of RM159.3m due within 12 months, and liabilities of RM85.5m due beyond 12 months. Offsetting this, it had RM57.8m in cash and RM65.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM122.0m.

When you consider that this deficiency exceeds the company's RM115.0m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Melewar Industrial Group Berhad's net debt is only 0.78 times its EBITDA. And its EBIT easily covers its interest expense, being 16.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It is just as well that Melewar Industrial Group Berhad's load is not too heavy, because its EBIT was down 24% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Melewar Industrial Group Berhad will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Considering the last three years, Melewar Industrial Group Berhad actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Melewar Industrial Group Berhad's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Melewar Industrial Group Berhad to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Melewar Industrial Group 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.