These 4 Measures Indicate That P.A. Resources Berhad (KLSE:PA) Is Using Debt Reasonably Well

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.' 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. Importantly, P.A. Resources Berhad (KLSE:PA) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for P.A. Resources Berhad

What Is P.A. Resources Berhad's Debt?

As you can see below, P.A. Resources Berhad had RM8.43m of debt at September 2020, down from RM19.5m a year prior. However, it also had RM6.13m in cash, and so its net debt is RM2.30m.

How Strong Is P.A. Resources Berhad's Balance Sheet?

The latest balance sheet data shows that P.A. Resources Berhad had liabilities of RM20.8m due within a year, and liabilities of RM1.08m falling due after that. On the other hand, it had cash of RM6.13m and RM31.9m worth of receivables due within a year. So it actually has RM16.2m more liquid assets than total liabilities.

This surplus suggests that P.A. Resources Berhad has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Carrying virtually no net debt, P.A. Resources Berhad has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

P.A. Resources Berhad's net debt is only 0.12 times its EBITDA. And its EBIT covers its interest expense a whopping 13.6 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that P.A. Resources Berhad grew its EBIT by 140% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is P.A. Resources Berhad's earnings that will influence how the balance sheet holds up in the future. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last two years, P.A. Resources Berhad recorded negative free cash flow, in total. 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

P.A. Resources Berhad's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that P.A. Resources Berhad takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. To that end, you should be aware of the 2 warning signs we've spotted with P.A. Resources Berhad .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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