Kencana Agri (SGX:BNE) Has A Somewhat Strained Balance Sheet

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Kencana Agri Limited (SGX:BNE) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the SG Food industry.

What Is Kencana Agri's Net Debt?

As you can see below, Kencana Agri had US$216.2m of debt at June 2022, down from US$240.3m a year prior. However, it also had US$18.1m in cash, and so its net debt is US$198.2m.

How Strong Is Kencana Agri's Balance Sheet?

According to the last reported balance sheet, Kencana Agri had liabilities of US$116.1m due within 12 months, and liabilities of US$190.2m due beyond 12 months. On the other hand, it had cash of US$18.1m and US$37.7m worth of receivables due within a year. So its liabilities total US$250.4m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$30.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Kencana Agri would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Kencana Agri's net debt to EBITDA ratio of 4.0, we think its super-low interest cover of 2.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even more troubling is the fact that Kencana Agri actually let its EBIT decrease by 8.6% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Kencana Agri'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Kencana Agri actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Kencana Agri'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 converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Kencana Agri's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Kencana Agri is showing 4 warning signs in our investment analysis , and 2 of those are a bit concerning...

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.

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