Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is PETRONAS Chemicals Group Berhad's Debt?
As you can see below, at the end of September 2021, PETRONAS Chemicals Group Berhad had RM2.38b of debt, up from RM2.19b a year ago. Click the image for more detail. However, it does have RM15.0b in cash offsetting this, leading to net cash of RM12.6b.
How Healthy Is PETRONAS Chemicals Group Berhad's Balance Sheet?
According to the last reported balance sheet, PETRONAS Chemicals Group Berhad had liabilities of RM4.40b due within 12 months, and liabilities of RM6.03b due beyond 12 months. Offsetting this, it had RM15.0b in cash and RM2.71b in receivables that were due within 12 months. So it can boast RM7.27b more liquid assets than total liabilities.
This surplus suggests that PETRONAS Chemicals Group Berhad has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that PETRONAS Chemicals Group Berhad has more cash than debt is arguably a good indication that it can manage its debt safely.
Even more impressive was the fact that PETRONAS Chemicals Group Berhad grew its EBIT by 228% over twelve months. That boost will make it even easier to pay down debt going forward. 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 PETRONAS Chemicals Group Berhad can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. 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. During the last three years, PETRONAS Chemicals Group Berhad generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that PETRONAS Chemicals Group Berhad has net cash of RM12.6b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of RM4.8b, being 83% of its EBIT. So is PETRONAS Chemicals Group Berhad's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that PETRONAS Chemicals Group Berhad is showing 2 warning signs in our investment analysis , and 1 of those is concerning...
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.