OCK Group Berhad (KLSE:OCK) Takes On Some Risk With Its Use Of 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that OCK Group Berhad (KLSE:OCK) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 OCK Group Berhad

What Is OCK Group Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that OCK Group Berhad had RM431.2m of debt in December 2020, down from RM487.4m, one year before. However, because it has a cash reserve of RM71.9m, its net debt is less, at about RM359.3m.

A Look At OCK Group Berhad's Liabilities

The latest balance sheet data shows that OCK Group Berhad had liabilities of RM397.0m due within a year, and liabilities of RM369.6m falling due after that. On the other hand, it had cash of RM71.9m and RM288.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM406.3m.

This deficit is considerable relative to its market capitalization of RM537.8m, so it does suggest shareholders should keep an eye on OCK Group 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.

While OCK Group Berhad has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 2.2. The main reason for this is that it has such high depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) Either way there's no doubt the stock is using meaningful leverage. Unfortunately, OCK Group Berhad saw its EBIT slide 4.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if OCK Group Berhad can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, OCK Group Berhad's free cash flow amounted to 38% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over OCK Group Berhad's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Once we consider all the factors above, together, it seems to us that OCK Group Berhad's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example OCK Group Berhad has 2 warning signs (and 1 which is concerning) we think you should know about.

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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