We Think D & O Green Technologies Berhad (KLSE:D&O) Is Taking Some Risk With Its Debt

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 note that D & O Green Technologies Berhad (KLSE:D&O) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for D & O Green Technologies Berhad

What Is D & O Green Technologies Berhad's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2023 D & O Green Technologies Berhad had debt of RM457.4m, up from RM232.5m in one year. However, it does have RM261.5m in cash offsetting this, leading to net debt of about RM196.0m.

How Strong Is D & O Green Technologies Berhad's Balance Sheet?

The latest balance sheet data shows that D & O Green Technologies Berhad had liabilities of RM541.7m due within a year, and liabilities of RM205.6m falling due after that. Offsetting these obligations, it had cash of RM261.5m as well as receivables valued at RM282.0m due within 12 months. So it has liabilities totalling RM203.8m more than its cash and near-term receivables, combined.

Since publicly traded D & O Green Technologies Berhad shares are worth a total of RM6.62b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

D & O Green Technologies Berhad's net debt is only 0.90 times its EBITDA. And its EBIT covers its interest expense a whopping 37.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, D & O Green Technologies Berhad's EBIT dived 20%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine D & O Green Technologies Berhad's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, D & O Green Technologies 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

Neither D & O Green Technologies Berhad's ability to convert EBIT to free cash flow nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that D & O Green Technologies Berhad is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 2 warning signs for D & O Green Technologies Berhad you should be aware of, and 1 of them is a bit concerning.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.