Is Selangor Dredging Berhad (KLSE:SDRED) A Risky Investment?

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. We can see that Selangor Dredging Berhad (KLSE:SDRED) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Selangor Dredging Berhad

How Much Debt Does Selangor Dredging Berhad Carry?

The image below, which you can click on for greater detail, shows that at March 2023 Selangor Dredging Berhad had debt of RM445.9m, up from RM415.5m in one year. However, it does have RM85.0m in cash offsetting this, leading to net debt of about RM360.9m.

How Healthy Is Selangor Dredging Berhad's Balance Sheet?

We can see from the most recent balance sheet that Selangor Dredging Berhad had liabilities of RM407.0m falling due within a year, and liabilities of RM141.2m due beyond that. On the other hand, it had cash of RM85.0m and RM170.0m worth of receivables due within a year. So it has liabilities totalling RM293.2m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM204.5m, we think shareholders really should watch Selangor Dredging 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 8.5 hit our confidence in Selangor Dredging Berhad like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. However, the silver lining was that Selangor Dredging Berhad achieved a positive EBIT of RM36m in the last twelve months, an improvement on the prior year's loss. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Selangor Dredging 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. Over the last year, Selangor Dredging Berhad saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Selangor Dredging Berhad's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Taking into account all the aforementioned factors, it looks like Selangor Dredging Berhad has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. We've identified 5 warning signs with Selangor Dredging Berhad (at least 3 which don't sit too well with us) , and understanding them should be part of your investment process.

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.