We Think Ranhill Utilities Berhad (KLSE:RANHILL) Is Taking Some Risk With Its Debt

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.' 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 Ranhill Utilities Berhad (KLSE:RANHILL) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Ranhill Utilities Berhad

What Is Ranhill Utilities Berhad's Debt?

As you can see below, Ranhill Utilities Berhad had RM1.07b of debt at June 2020, down from RM1.16b a year prior. However, it does have RM291.4m in cash offsetting this, leading to net debt of about RM775.5m.

How Strong Is Ranhill Utilities Berhad's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ranhill Utilities Berhad had liabilities of RM509.5m due within 12 months and liabilities of RM1.38b due beyond that. Offsetting these obligations, it had cash of RM291.4m as well as receivables valued at RM371.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RM1.23b.

Given this deficit is actually higher than the company's market capitalization of RM876.7m, we think shareholders really should watch Ranhill Utilities Berhad's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

While Ranhill Utilities Berhad's low debt to EBITDA ratio of 1.3 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Ranhill Utilities Berhad's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Ranhill Utilities 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.

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. Over the most recent three years, Ranhill Utilities 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

Ranhill Utilities Berhad's level of total liabilities was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its conversion of EBIT to free cash flow was refreshing. We should also note that Water Utilities industry companies like Ranhill Utilities Berhad commonly do use debt without problems. We think that Ranhill Utilities Berhad's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Ranhill Utilities Berhad is showing 3 warning signs in our investment analysis , and 1 of those can't be ignored...

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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