Tomei Consolidated Berhad (KLSE:TOMEI) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Tomei Consolidated Berhad (KLSE:TOMEI) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tomei Consolidated Berhad

What Is Tomei Consolidated Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Tomei Consolidated Berhad had RM192.2m of debt, an increase on RM169.6m, over one year. However, because it has a cash reserve of RM40.4m, its net debt is less, at about RM151.8m.

How Healthy Is Tomei Consolidated Berhad's Balance Sheet?

According to the last reported balance sheet, Tomei Consolidated Berhad had liabilities of RM228.4m due within 12 months, and liabilities of RM28.0m due beyond 12 months. On the other hand, it had cash of RM40.4m and RM73.3m worth of receivables due within a year. So it has liabilities totalling RM142.7m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of RM140.0m, we think shareholders really should watch Tomei Consolidated Berhad's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a debt to EBITDA ratio of 1.8, Tomei Consolidated Berhad uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.8 times its interest expenses harmonizes with that theme. It is well worth noting that Tomei Consolidated Berhad's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tomei Consolidated Berhad's earnings that will influence how the balance sheet holds up in the future. 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, Tomei Consolidated Berhad reported free cash flow worth 18% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither Tomei Consolidated Berhad's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Tomei Consolidated Berhad is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Tomei Consolidated Berhad you should be aware of, and 1 of them doesn't sit too well with us.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.