Eastern & Oriental Berhad (KLSE:E&O) Seems To Be Using A Lot Of Debt

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.' 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 note that Eastern & Oriental Berhad (KLSE:E&O) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its 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 RM1.13b of debt in December 2020, down from RM1.30b, one year before. However, because it has a cash reserve of RM331.9m, its net debt is less, at about RM801.7m.

How Healthy Is Eastern & Oriental Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Eastern & Oriental Berhad had liabilities of RM481.6m due within 12 months and liabilities of RM1.15b due beyond that. On the other hand, it had cash of RM331.9m and RM139.2m worth of receivables due within a year. So its liabilities total RM1.16b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of RM866.0m, we think shareholders really should watch Eastern & Oriental Berhad's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Eastern & Oriental Berhad has a rather high debt to EBITDA ratio of 11.3 which suggests a meaningful debt load. However, its interest coverage of 3.8 is reasonably strong, which is a good sign. Even worse, Eastern & Oriental Berhad saw its EBIT tank 68% over the last 12 months. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Eastern & Oriental Berhad can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Eastern & Oriental Berhad recorded free cash flow worth 59% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Eastern & Oriental Berhad's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Eastern & Oriental Berhad to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For example, we've discovered 3 warning signs for Eastern & Oriental Berhad (1 doesn't sit too well with us!) that you should be aware of before investing here.

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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