We Think Kencana Agri (SGX:BNE) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Kencana Agri Limited (SGX:BNE) 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. 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. 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.

See our latest analysis for Kencana Agri

What Is Kencana Agri's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Kencana Agri had US$201.8m of debt in December 2020, down from US$259.1m, one year before. On the flip side, it has US$13.9m in cash leading to net debt of about US$187.9m.

How Healthy Is Kencana Agri's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Kencana Agri had liabilities of US$110.5m due within 12 months and liabilities of US$210.3m due beyond that. Offsetting this, it had US$13.9m in cash and US$35.5m in receivables that were due within 12 months. So its liabilities total US$271.3m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$36.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Kencana Agri would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Kencana Agri shareholders face the double whammy of a high net debt to EBITDA ratio (5.6), and fairly weak interest coverage, since EBIT is just 1.1 times the interest expense. This means we'd consider it to have a heavy debt load. However, one redeeming factor is that Kencana Agri grew its EBIT at 17% over the last 12 months, boosting its ability to handle its debt. 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 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, Kencana Agri actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Kencana Agri's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for Kencana Agri you should be aware of, and 1 of them is a bit concerning.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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