Gromutual Berhad (KLSE:GMUTUAL) Has A Somewhat Strained Balance Sheet

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Gromutual Berhad (KLSE:GMUTUAL) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Gromutual Berhad

What Is Gromutual Berhad's Net Debt?

As you can see below, Gromutual Berhad had RM61.5m of debt at September 2020, down from RM65.3m a year prior. However, it does have RM22.1m in cash offsetting this, leading to net debt of about RM39.4m.

How Healthy Is Gromutual Berhad's Balance Sheet?

The latest balance sheet data shows that Gromutual Berhad had liabilities of RM64.7m due within a year, and liabilities of RM17.6m falling due after that. Offsetting this, it had RM22.1m in cash and RM14.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM46.1m.

While this might seem like a lot, it is not so bad since Gromutual Berhad has a market capitalization of RM97.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

With net debt to EBITDA of 3.8 Gromutual Berhad has a fairly noticeable amount of debt. But the high interest coverage of 7.3 suggests it can easily service that debt. Sadly, Gromutual Berhad's EBIT actually dropped 5.8% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Gromutual Berhad will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Gromutual 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

We'd go so far as to say Gromutual Berhad's conversion of EBIT to free cash flow was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Gromutual Berhad's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Gromutual Berhad has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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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