Is PETRONAS Chemicals Group Berhad (KLSE:PCHEM) Using Too Much Debt?

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.' 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 PETRONAS Chemicals Group Berhad (KLSE:PCHEM) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 PETRONAS Chemicals Group Berhad

How Much Debt Does PETRONAS Chemicals Group Berhad Carry?

As you can see below, PETRONAS Chemicals Group Berhad had RM2.86b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have RM9.07b in cash offsetting this, leading to net cash of RM6.21b.

How Strong Is PETRONAS Chemicals Group Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that PETRONAS Chemicals Group Berhad had liabilities of RM7.71b due within 12 months and liabilities of RM9.38b due beyond that. Offsetting these obligations, it had cash of RM9.07b as well as receivables valued at RM3.79b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM4.24b.

Given PETRONAS Chemicals Group Berhad has a humongous market capitalization of RM58.4b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, PETRONAS Chemicals Group Berhad also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact PETRONAS Chemicals Group Berhad's saving grace is its low debt levels, because its EBIT has tanked 68% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine PETRONAS Chemicals Group Berhad's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While PETRONAS Chemicals 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. Over the last three years, PETRONAS Chemicals Group Berhad recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

We could understand if investors are concerned about PETRONAS Chemicals Group Berhad's liabilities, but we can be reassured by the fact it has has net cash of RM6.21b. And it impressed us with free cash flow of RM3.4b, being 94% of its EBIT. So we don't have any problem with PETRONAS Chemicals Group Berhad's use of debt. 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. Be aware that PETRONAS Chemicals Group Berhad is showing 2 warning signs in our investment analysis , you should know about...

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.