Legendary fund manager Li Lu (whom Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We can see that Scanwolf Corporation Berhad (KLSE: SCNWOLF) uses debt in its business. But does this debt worry shareholders?

When is debt a problem?

Debts and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. If things really go wrong, lenders can take over the business. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. When we look at debt levels, we first consider both liquidity and debt levels.

See our latest review for Scanwolf Corporation Berhad

What is the debt of Scanwolf Corporation Berhad?

The image below, which you can click for more details, shows Scanwolf Corporation Berhad owed RM 28.1 million in debt at the end of June 2021, a reduction from RM 31.0 million on a year. Net debt is about the same because it doesn’t have a lot of cash.

How healthy is Scanwolf Corporation Berhad’s balance sheet?

The latest balance sheet data shows Scanwolf Corporation Berhad had debts of RM 54.8 million due within one year, and RM 16.9 million debts due thereafter. In compensation for these obligations, he had cash of RM 140.0k as well as receivables valued at RM 7.64 million due within 12 months. Thus, its liabilities are RM 63.9 million more than the combination of its cash and short-term receivables.

This is a mountain of leverage compared to its market cap of RM 76.0 million. This suggests that shareholders would be heavily diluted if the company needed to consolidate its balance sheet quickly.

We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

The shareholders of Scanwolf Corporation Berhad are faced with the double whammy of a high net debt to EBITDA ratio (6.1) and relatively low interest coverage, since EBIT is only 0.83 times the interest charges. This means that we would consider him to be in heavy debt. However, the bright side is that Scanwolf Corporation Berhad achieved a positive EBIT of RM 1.3 million in the past twelve months, an improvement over the loss of the previous year. The balance sheet is clearly the area you need to focus on when analyzing debt. But you can’t look at debt in isolation; since Scanwolf Corporation Berhad will need income to pay off this debt. So if you want to know more about its profits, it may be worth checking out this long term profit trend chart.

Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. It is therefore worth checking to what extent earnings before interest and taxes (EBIT) are backed by free cash flow. Over the past year, Scanwolf Corporation Berhad has actually generated more free cash flow than EBIT. This kind of cash conversion makes us as excited as the crowd when the pace drops at a Daft Punk concert.

Our point of view

The interest coverage and net debt on EBITDA of Scanwolf Corporation Berhad certainly weighs on this, in our opinion. But its conversion from EBIT to free cash flow tells a very different story and suggests some resilience. When we consider all the factors mentioned, it seems to us that Scanwolf Corporation Berhad is taking risks with its recourse to debt. While this debt may increase returns, we believe the company now has sufficient leverage. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 4 warning signs for Scanwolf Corporation Berhad (2 of which make us uncomfortable!) to know.

At the end of the day, sometimes it’s easier to focus on businesses that don’t even need to go into debt. Readers can access a list of growth stocks with zero net debt 100% free, at present.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.

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