Here's Why Seal Berhad (KLSE:SEAL) Has A Meaningful Debt Burden

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.' 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. As with many other companies Seal Incorporated Berhad (KLSE:SEAL) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Seal Berhad

What Is Seal Berhad's Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Seal Berhad had debt of RM88.5m, up from RM77.3m in one year. However, it does have RM6.51m in cash offsetting this, leading to net debt of about RM82.0m.

How Healthy Is Seal Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Seal Berhad had liabilities of RM79.3m due within 12 months and liabilities of RM62.5m due beyond that. On the other hand, it had cash of RM6.51m and RM161.3m worth of receivables due within a year. So it actually has RM26.0m more liquid assets than total liabilities.

This excess liquidity is a great indication that Seal Berhad's balance sheet is almost as strong as Fort Knox. With this in mind one could posit that its balance sheet means the company is able to handle some adversity.

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

Seal Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (15.8), and fairly weak interest coverage, since EBIT is just 1.2 times the interest expense. This means we'd consider it to have a heavy debt load. Worse, Seal Berhad's EBIT was down 67% 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. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Seal Berhad will need earnings to service that debt. 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Seal Berhad's free cash flow amounted to 45% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Seal Berhad's interest cover makes us cautious about it, its track record of (not) growing its EBIT is no better. But on the brighter side of life, its level of total liabilities leaves us feeling more frolicsome. Taking the abovementioned factors together we do think Seal Berhad's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Seal Berhad 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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