We Think Indofood Agri Resources (SGX:5JS) Is Taking Some Risk With Its Debt

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Indofood Agri Resources Ltd. (SGX:5JS) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Indofood Agri Resources

How Much Debt Does Indofood Agri Resources Carry?

As you can see below, Indofood Agri Resources had Rp11t of debt at December 2020, down from Rp12t a year prior. However, it does have Rp2.45t in cash offsetting this, leading to net debt of about Rp8.91t.

How Healthy Is Indofood Agri Resources' Balance Sheet?

We can see from the most recent balance sheet that Indofood Agri Resources had liabilities of Rp9.20t falling due within a year, and liabilities of Rp7.84t due beyond that. Offsetting this, it had Rp2.45t in cash and Rp1.30t in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by Rp13t.

The deficiency here weighs heavily on the Rp4.42t company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Indofood Agri Resources 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While we wouldn't worry about Indofood Agri Resources's net debt to EBITDA ratio of 2.8, we think its super-low interest cover of 2.2 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The silver lining is that Indofood Agri Resources grew its EBIT by 158% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. There's no doubt that we learn most about debt from the balance sheet. But it is Indofood Agri Resources's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Indofood Agri Resources created free cash flow amounting to 7.5% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

To be frank both Indofood Agri Resources's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. We're quite clear that we consider Indofood Agri Resources 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. 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. Case in point: We've spotted 1 warning sign for Indofood Agri Resources you should be aware of.

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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