Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. Like many other companies Sarawak Berhad oil palms (KLSE:SOP) uses debt. But the real question is whether this debt makes the business risky.
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. 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. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for Sarawak Oil Palms Berhad
What is Sarawak Oil Palms Berhad’s net debt?
As you can see below, Sarawak Oil Palms Berhad had a debt of RM1.04 billion in September 2021, up from RM1.15 billion the previous year. However, since he has a cash reserve of RM954.9 million, his net debt is less at around RM83.4 million.
How strong is Sarawak Oil Palms Berhad’s balance sheet?
According to the latest published balance sheet, Sarawak Oil Palms Berhad had liabilities of RM1.02 billion due within 12 months and liabilities of RM726.3 million due beyond 12 months. In return, he had RM954.9 million in cash and RM347.0 million in receivables due within 12 months. Thus, its liabilities total RM447.5 million more than the combination of its cash and short-term receivables.
Of course, Sarawak Oil Palms Berhad has a market cap of RM3.07b, so those liabilities are probably manageable. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). 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 ).
Sarawak Oil Palms Berhad has a low net debt to EBITDA ratio of just 0.13. And its EBIT easily covers its interest charges, which is 29.6 times the size. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. On top of that, we are pleased to report that Sarawak Oil Palms Berhad increased its EBIT by 40%, reducing the specter of future debt repayments. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Sarawak Oil Palms Berhad’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Sarawak Oil Palms Berhad has recorded free cash flow of 91% of its EBIT, which is higher than we would normally expect. This puts him in a very strong position to pay off the debt.
Our point of view
The good news is that Sarawak Oil Palms Berhad’s demonstrated ability to cover its interest charges with its EBIT delights us like a fluffy puppy does a toddler. And this is only the beginning of good news since its conversion of EBIT into free cash flow is also very pleasing. We believe that Sarawak Oil Palms Berhad is no more indebted to its lenders than the birds are to birdwatchers. In our view, he has a healthy and happy record. 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. For example, we found 2 warning signs for Sarawak Oil Palms Berhad (1 is significant!) which you should be aware of before investing here.
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.