Quality Concrete Holdings Berhad (KLSE:QUALITY) Takes On Some Risk With Its Use Of 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.' 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 Quality Concrete Holdings Berhad (KLSE:QUALITY) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

View our latest analysis for Quality Concrete Holdings Berhad

How Much Debt Does Quality Concrete Holdings Berhad Carry?

The image below, which you can click on for greater detail, shows that Quality Concrete Holdings Berhad had debt of RM56.9m at the end of October 2020, a reduction from RM71.4m over a year. On the flip side, it has RM5.90m in cash leading to net debt of about RM51.0m.

How Strong Is Quality Concrete Holdings Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Quality Concrete Holdings Berhad had liabilities of RM113.7m due within 12 months and liabilities of RM13.7m due beyond that. Offsetting these obligations, it had cash of RM5.90m as well as receivables valued at RM59.0m due within 12 months. So it has liabilities totalling RM62.5m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM53.3m, we think shareholders really should watch Quality Concrete Holdings Berhad's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Quality Concrete Holdings Berhad's net debt to EBITDA ratio of 4.6, we think its super-low interest cover of 2.1 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Quality Concrete Holdings Berhad is that it turned last year's EBIT loss into a gain of RM6.0m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Quality Concrete Holdings 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Quality Concrete Holdings Berhad actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On the face of it, Quality Concrete Holdings Berhad's level of total liabilities left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Quality Concrete Holdings Berhad's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Quality Concrete Holdings Berhad (of which 2 make us uncomfortable!) you should know about.

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. 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.
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