Here's Why Xin Hwa Holdings Berhad (KLSE:XINHWA) Is Weighed Down By Its Debt Load

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Xin Hwa Holdings Berhad (KLSE:XINHWA) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Xin Hwa Holdings Berhad

What Is Xin Hwa Holdings Berhad's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Xin Hwa Holdings Berhad had RM128.7m of debt, an increase on RM84.0m, over one year. However, it also had RM5.02m in cash, and so its net debt is RM123.7m.

How Healthy Is Xin Hwa Holdings Berhad's Balance Sheet?

We can see from the most recent balance sheet that Xin Hwa Holdings Berhad had liabilities of RM49.3m falling due within a year, and liabilities of RM111.6m due beyond that. On the other hand, it had cash of RM5.02m and RM28.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM127.3m.

Given this deficit is actually higher than the company's market capitalization of RM98.5m, we think shareholders really should watch Xin Hwa Holdings Berhad's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

Weak interest cover of 0.99 times and a disturbingly high net debt to EBITDA ratio of 8.2 hit our confidence in Xin Hwa Holdings Berhad like a one-two punch to the gut. The debt burden here is substantial. Even worse, Xin Hwa Holdings Berhad saw its EBIT tank 47% over the last 12 months. 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 Xin Hwa Holdings 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Xin Hwa Holdings Berhad generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

To be frank both Xin Hwa Holdings Berhad's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Xin Hwa Holdings Berhad's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 5 warning signs for Xin Hwa Holdings Berhad (of which 2 are a bit unpleasant!) 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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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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