Is EcoFirst Consolidated Bhd (KLSE:ECOFIRS) Using Too Much 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.' 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. As with many other companies EcoFirst Consolidated Bhd (KLSE:ECOFIRS) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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.

View our latest analysis for EcoFirst Consolidated Bhd

What Is EcoFirst Consolidated Bhd's Debt?

As you can see below, at the end of February 2022, EcoFirst Consolidated Bhd had RM190.6m of debt, up from RM168.4m a year ago. Click the image for more detail. On the flip side, it has RM9.94m in cash leading to net debt of about RM180.7m.

How Strong Is EcoFirst Consolidated Bhd's Balance Sheet?

According to the last reported balance sheet, EcoFirst Consolidated Bhd had liabilities of RM201.8m due within 12 months, and liabilities of RM203.1m due beyond 12 months. On the other hand, it had cash of RM9.94m and RM37.3m worth of receivables due within a year. So it has liabilities totalling RM357.6m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of RM517.9m, so it does suggest shareholders should keep an eye on EcoFirst Consolidated Bhd's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

EcoFirst Consolidated Bhd shareholders face the double whammy of a high net debt to EBITDA ratio (12.0), and fairly weak interest coverage, since EBIT is just 2.1 times the interest expense. This means we'd consider it to have a heavy debt load. On a lighter note, we note that EcoFirst Consolidated Bhd grew its EBIT by 21% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. The balance sheet is clearly the area to focus on when you are analysing debt. But it is EcoFirst Consolidated Bhd'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, EcoFirst Consolidated Bhd saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both EcoFirst Consolidated Bhd's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that EcoFirst Consolidated Bhd has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the 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. For example, we've discovered 3 warning signs for EcoFirst Consolidated Bhd (1 shouldn't be ignored!) that you should be aware of before investing here.

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.