Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Hap Seng Consolidated Berhad (KLSE: HAPSENG) uses debt. But should shareholders worry about its use of debt?
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. In the worst case, 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 at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Hap Seng Consolidated Berhad
What is Hap Seng Consolidated Berhad’s net debt?
The graph below, which you can click on for more details, shows that Hap Seng Consolidated Berhad had debt of RM6.32 billion in December 2021; about the same as the previous year. However, since he has a cash reserve of RM3.09 billion, his net debt is less at around RM3.22 billion.
How strong is Hap Seng Consolidated Berhad’s balance sheet?
We can see from the most recent balance sheet that Hap Seng Consolidated Berhad had liabilities of RM3.95 billion maturing within a year, and liabilities of RM4.75 billion beyond that. On the other hand, it had cash of RM3.09 billion and RM2.02 billion of receivables due within the year. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by RM3.60 billion.
Of course, Hap Seng Consolidated Berhad has a market cap of RM18.2b, so those liabilities are probably manageable. But there are enough liabilities that we certainly recommend that shareholders continue to monitor the balance sheet in the future.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Hap Seng Consolidated Berhad’s net debt of 1.8x EBITDA suggests judicious use of debt. And the fact that its trailing twelve months EBIT was 9.0 times its interest expense aligns with that theme. It should also be noted that Hap Seng Consolidated Berhad has increased its EBIT by a very respectable 28% over the past year, improving its ability to repay debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is the earnings of Hap Seng Consolidated Berhad that will influence the balance sheet going forward. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Hap Seng Consolidated Berhad has produced strong free cash flow equivalent to 66% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
Hap Seng Consolidated Berhad’s EBIT growth rate suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And the good news doesn’t stop there, since its conversion of EBIT into free cash flow also confirms this impression! Zooming out, Hap Seng Consolidated Berhad appears to be using debt quite sensibly; and that gets the green light from us. After all, reasonable leverage can increase return on equity. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 2 warning signs we spotted with Hap Seng Consolidated Berhad (including 1 which is a little worrying).
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.