These 4 Measures Indicate That South Malaysia Industries Berhad (KLSE:SMI) Is Using Debt Reasonably Well

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, South Malaysia Industries Berhad (KLSE:SMI) 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for South Malaysia Industries Berhad

How Much Debt Does South Malaysia Industries Berhad Carry?

You can click the graphic below for the historical numbers, but it shows that South Malaysia Industries Berhad had RM20.5m of debt in September 2021, down from RM26.1m, one year before. However, because it has a cash reserve of RM13.2m, its net debt is less, at about RM7.37m.

A Look At South Malaysia Industries Berhad's Liabilities

According to the last reported balance sheet, South Malaysia Industries Berhad had liabilities of RM21.6m due within 12 months, and liabilities of RM9.50m due beyond 12 months. Offsetting these obligations, it had cash of RM13.2m as well as receivables valued at RM14.0m due within 12 months. So it has liabilities totalling RM3.92m more than its cash and near-term receivables, combined.

Given South Malaysia Industries Berhad has a market capitalization of RM48.3m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

South Malaysia Industries Berhad has a low debt to EBITDA ratio of only 0.39. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it's fair to say it can handle debt like a hotshot teppanyaki chef handles cooking. Although South Malaysia Industries Berhad made a loss at the EBIT level, last year, it was also good to see that it generated RM17m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is South Malaysia Industries Berhad's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, South Malaysia Industries Berhad generated free cash flow amounting to a very robust 98% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that South Malaysia Industries Berhad's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think South Malaysia Industries Berhad's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for South Malaysia Industries Berhad (1 is concerning!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.