Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Xin Hwa Holdings Berhad (KLSE:XINHWA) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Xin Hwa Holdings Berhad's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Xin Hwa Holdings Berhad had debt of RM132.7m, up from RM113.5m in one year. However, it does have RM4.10m in cash offsetting this, leading to net debt of about RM128.6m.
How Strong Is Xin Hwa Holdings Berhad's Balance Sheet?
The latest balance sheet data shows that Xin Hwa Holdings Berhad had liabilities of RM43.5m due within a year, and liabilities of RM119.8m falling due after that. Offsetting these obligations, it had cash of RM4.10m as well as receivables valued at RM31.5m due within 12 months. So its liabilities total RM127.7m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of RM90.1m, 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.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Weak interest cover of 1.1 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. This means we'd consider it to have a heavy debt load. Even worse, Xin Hwa Holdings Berhad saw its EBIT tank 43% 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Xin Hwa Holdings 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, 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. Over the last three years, Xin Hwa Holdings Berhad recorded free cash flow worth a fulsome 83% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
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 at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. 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. 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. To that end, you should learn about the 4 warning signs we've spotted with Xin Hwa Holdings Berhad (including 2 which are significant) .
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. 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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