Xin Hwa Holdings Berhad (KLSE:XINHWA) Takes On Some Risk With Its Use Of Debt

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Xin Hwa Holdings Berhad (KLSE:XINHWA) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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.

Check out our latest analysis for Xin Hwa Holdings Berhad

What Is Xin Hwa Holdings Berhad's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Xin Hwa Holdings Berhad had RM140.7m of debt, an increase on RM123.2m, over one year. On the flip side, it has RM3.75m in cash leading to net debt of about RM136.9m.

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

According to the last reported balance sheet, Xin Hwa Holdings Berhad had liabilities of RM56.6m due within 12 months, and liabilities of RM122.1m due beyond 12 months. Offsetting these obligations, it had cash of RM3.75m as well as receivables valued at RM37.2m due within 12 months. So its liabilities total RM137.8m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the RM88.3m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Xin Hwa Holdings Berhad would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Xin Hwa Holdings Berhad shareholders face the double whammy of a high net debt to EBITDA ratio (7.9), and fairly weak interest coverage, since EBIT is just 2.3 times the interest expense. The debt burden here is substantial. Even more troubling is the fact that Xin Hwa Holdings Berhad actually let its EBIT decrease by 9.7% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Xin Hwa Holdings Berhad recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

On the face of it, Xin Hwa Holdings Berhad's level of total liabilities left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider Xin Hwa Holdings Berhad to be really rather risky, as a result of its balance sheet health. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 4 warning signs for Xin Hwa Holdings Berhad (2 can't be ignored!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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.

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