Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. 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. Above all, Pelikan International Corporation Berhad (KLSE: PELIKAN) is in debt. But should shareholders worry about its use of debt?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. 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.
Check out our latest review for Pelikan International Corporation Berhad
What is the net debt of Pelikan International Corporation Berhad?
The image below, which you can click on for more details, shows that Pelikan International Corporation Berhad had debt of RM391.6 million at the end of June 2021, a reduction from RM457.8 million over a year. However, since he has a cash reserve of RM30.3 million, his net debt is less at around RM361.3 million.
A look at the responsibilities of Pelikan International Corporation Berhad
According to the latest published balance sheet, Pelikan International Corporation Berhad had liabilities of RM517.5 million due within 12 months and liabilities of RM405.5 million due beyond 12 months. As compensation for these obligations, it had cash of RM30.3 million and receivables valued at RM294.4 million due within 12 months. Thus, its liabilities outweigh the sum of its cash and receivables (short term) of RM598.4 million.
The deficiency here weighs heavily on the company itself, at RM301.6 million, like a child struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Pelikan International Corporation Berhad would likely need a major recapitalization if it were to pay its creditors today.
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). Thus, we consider debt to earnings with and without amortization and depreciation expense.
A low interest coverage of 2.0x and an extremely high net debt to EBITDA ratio of 7.1 shook our confidence in Pelikan International Corporation Berhad like a punch in the gut. The debt burden here is considerable. However, a redeeming factor is that Pelikan International Corporation Berhad has increased its EBIT by 10% over the past 12 months, strengthening its ability to manage its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is the profits of Pelikan International Corporation Berhad that will influence the balance sheet in the future. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
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, Pelikan International Corporation Berhad has recorded free cash flow of 59% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
To be frank, Pelikan International Corporation Berhad’s net debt to EBITDA and track record of keeping total liabilities under control makes us rather uncomfortable with its level of leverage. But on the bright side, its conversion from EBIT to free cash flow is a good sign and makes us more optimistic. We are quite clear that we consider Pelikan International Corporation Berhad to be really quite risky, given the health of its balance sheet. We are therefore almost as suspicious of this stock as a hungry kitten of falling into its owner’s fish pond: once bitten, twice shy, as they say. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. Be aware that Pelikan International Corporation Berhad shows 3 warning signs in our investment analysis , and 2 of them are potentially serious…
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-flowing growth stocks without further ado.
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.
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