Here's Why Tomei Consolidated Berhad (KLSE:TOMEI) Can Manage Its Debt Responsibly

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.' 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 Tomei Consolidated Berhad (KLSE:TOMEI) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Tomei Consolidated Berhad

What Is Tomei Consolidated Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that Tomei Consolidated Berhad had debt of RM162.7m at the end of March 2021, a reduction from RM181.6m over a year. On the flip side, it has RM16.2m in cash leading to net debt of about RM146.5m.

How Healthy Is Tomei Consolidated Berhad's Balance Sheet?

We can see from the most recent balance sheet that Tomei Consolidated Berhad had liabilities of RM196.8m falling due within a year, and liabilities of RM6.81m due beyond that. On the other hand, it had cash of RM16.2m and RM52.7m worth of receivables due within a year. So it has liabilities totalling RM134.7m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of RM140.0m, so it does suggest shareholders should keep an eye on Tomei Consolidated Berhad's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Tomei Consolidated Berhad's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 6.2 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Tomei Consolidated Berhad is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 114% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Tomei Consolidated 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Tomei Consolidated Berhad produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

On our analysis Tomei Consolidated Berhad's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Tomei Consolidated Berhad's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Case in point: We've spotted 3 warning signs for Tomei Consolidated Berhad you should be aware of.

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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