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.' 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 Selangor Dredging Berhad (KLSE:SDRED) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. 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.

See our latest analysis for Selangor Dredging Berhad

What Is Selangor Dredging Berhad's Debt?

The chart below, which you can click on for greater detail, shows that Selangor Dredging Berhad had RM415.5m in debt in March 2022; about the same as the year before. However, because it has a cash reserve of RM111.3m, its net debt is less, at about RM304.2m.

A Look At Selangor Dredging Berhad's Liabilities

Zooming in on the latest balance sheet data, we can see that Selangor Dredging Berhad had liabilities of RM360.5m due within 12 months and liabilities of RM152.5m due beyond that. Offsetting these obligations, it had cash of RM111.3m as well as receivables valued at RM58.4m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM343.3m.

The deficiency here weighs heavily on the RM187.5m 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, Selangor Dredging Berhad would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Weak interest cover of 0.24 times and a disturbingly high net debt to EBITDA ratio of 40.9 hit our confidence in Selangor Dredging Berhad like a one-two punch to the gut. The debt burden here is substantial. One redeeming factor for Selangor Dredging Berhad is that it turned last year's EBIT loss into a gain of RM2.9m, over the last twelve months. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Selangor Dredging Berhad actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both Selangor Dredging Berhad's interest cover 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. We're quite clear that we consider Selangor Dredging Berhad to be really rather risky, as a result of its balance sheet health. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Selangor Dredging Berhad you should be aware of, and 1 of them is concerning.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.