The external fund manager, backed by Charlie Munger of Berkshire Hathaway, Li Lu, makes no bones about it when he says, “The biggest investment risk is not price volatility, but whether you will suffer permanent capital losses.” When we think about how risky a business is, we always like to look at the use of debt, as over-indebtedness can lead to ruin. We can see that Turiya Berhad (KLSE:TURIYA) does use debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt entail?
Debt is a tool to help companies grow, but if a company is unable to pay off its lenders, it is at their mercy. When things go really bad, the lenders can take control of the company. While not too common, we often see indebted companies permanently diluting their shareholders as lenders force them to raise capital at a difficult price. Of course, many companies use debt to finance growth, with no negative consequences. The first thing to do when considering how much debt a company uses is to look at its cash and debt together.
What is Turiya Berhad’s fault?
The chart below, which you can click on for more details, shows that Turiya Berhad had RM 38.7 million in debt in December 2020; about the same as the year before. However, since it has a cash reserve of RM 6.76 million, its net debt is less, at about RM 32.0 million.
How strong is Turiya Berhad’s balance sheet?
If we zoom in on the most recent balance sheet data, we can see that Turiya Berhad had liabilities of RM6.46 million to be paid within 12 months and liabilities of RM40.2 million to be paid thereafter. To offset these obligations, it had cash of RM 6.76 million and receivables of RM 3.88 million to be paid within 12 months. Thus, his liabilities total RM 36.1 million more than the combination of his cash and receivables.
This is a huge leverage against the market cap of 52.6 million RM. This suggests that shareholders would be highly diluted if the company had to strengthen its balance sheet quickly.
To upgrade a company’s debt relative to revenue, we calculate net debt divided by revenue before interest, taxes, depreciation, and amortization (EBITDA) and revenue before interest and tax (EBIT) divided by interest expense (are interest coverage). In this way, we take into account both the absolute amount of the debt and the interest rates paid on it.
Shareholders of Turiya Berhad are facing the double blow of a high net debt-to-EBITDA ratio (6.0) and rather weak interest coverage, as EBIT is only 1.2 times the interest expense. The debt burden here is considerable. The good news is that Turiya Berhad has grown its EBIT at a smooth 52% over the past twelve months. Like a mother’s loving embrace of a newborn, such growth builds resilience, putting the company in a stronger position to manage its debts. The balance sheet is clearly the area to focus on when analyzing debt. But you can’t see debt completely isolated; as Turiya Berhad needs income to repay that debt. So if you want to know more about the earnings, it might be worth checking out this graph of the long-term profit trend.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard money. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Turiya Berhad has produced solid free cash flow equal to 65% of its EBIT, roughly what we would expect. This free cash flow puts the company in a good position to pay off debt if necessary.
The interest coverage and net debt to Turiya Berhad’s EBITDA are certainly weighing heavily on us. But the good news is that it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it seems to us that Turiya Berhad is a somewhat risky investment due to its debts. Not all risk is bad, as it can increase stock returns when it pays off, but this debt risk is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. But in the end, any business can contain risks that exist off-balance sheet. To this end, you must be aware of the 3 warning signs we spotted with Turiya Berhad .
Are you more interested in a fast-growing company with a strong balance sheet, then take a look our list of net cash growth stocks without delay.
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