Malaysia Smelting Corporation Berhad (KLSE:MSC) Takes On Some Risk With Its Use Of Debt

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.' 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 Malaysia Smelting Corporation Berhad (KLSE:MSC) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Malaysia Smelting Corporation Berhad

What Is Malaysia Smelting Corporation Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Malaysia Smelting Corporation Berhad had RM328.4m of debt in March 2023, down from RM446.3m, one year before. However, it does have RM193.4m in cash offsetting this, leading to net debt of about RM135.1m.

A Look At Malaysia Smelting Corporation Berhad's Liabilities

The latest balance sheet data shows that Malaysia Smelting Corporation Berhad had liabilities of RM392.4m due within a year, and liabilities of RM118.1m falling due after that. On the other hand, it had cash of RM193.4m and RM30.1m worth of receivables due within a year. So it has liabilities totalling RM287.0m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Malaysia Smelting Corporation Berhad is worth RM1.02b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Malaysia Smelting Corporation Berhad's net debt is only 1.0 times its EBITDA. And its EBIT easily covers its interest expense, being 10.3 times the size. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for Malaysia Smelting Corporation Berhad if management cannot prevent a repeat of the 49% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Malaysia Smelting Corporation Berhad can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Malaysia Smelting Corporation Berhad recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Malaysia Smelting Corporation Berhad's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its interest cover was refreshing. Looking at all the angles mentioned above, it does seem to us that Malaysia Smelting Corporation Berhad is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example - Malaysia Smelting Corporation Berhad has 2 warning signs we think you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.