Does Eastern & Oriental Berhad (KLSE:E&O) Have A Healthy Balance Sheet?

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 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 note that Eastern & Oriental Berhad (KLSE:E&O) does have debt on its balance sheet. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Eastern & Oriental Berhad

What Is Eastern & Oriental Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Eastern & Oriental Berhad had RM1.08b of debt in September 2020, down from RM1.27b, one year before. However, it also had RM330.8m in cash, and so its net debt is RM744.5m.

A Look At Eastern & Oriental Berhad's Liabilities

Zooming in on the latest balance sheet data, we can see that Eastern & Oriental Berhad had liabilities of RM483.0m due within 12 months and liabilities of RM1.11b due beyond that. Offsetting these obligations, it had cash of RM330.8m as well as receivables valued at RM125.1m due within 12 months. So its liabilities total RM1.14b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the RM688.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Eastern & Oriental Berhad would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Eastern & Oriental Berhad has a rather high debt to EBITDA ratio of 7.8 which suggests a meaningful debt load. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. Worse, Eastern & Oriental Berhad's EBIT was down 56% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Eastern & Oriental 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Eastern & Oriental Berhad recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both Eastern & Oriental Berhad's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Eastern & Oriental Berhad's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. Take risks, for example - Eastern & Oriental Berhad has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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