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 seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that NestlÃ© (Malaysia) Berhad (KLSE: NESTLE) uses debt in his business. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. 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. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Discover our latest analysis for NestlÃ© (Malaysia) Berhad
What is the net debt of NestlÃ© (Malaysia) Berhad?
As you can see below, NestlÃ© (Malaysia) Berhad had a debt of RM100.0 million in September 2021, up from RM 150.0 million a year earlier. However, because he has a cash reserve of RM24.8 million, his net debt is less, at around RM75.2 million.
How strong is NestlÃ© (Malaysia) Berhad’s balance sheet?
Zooming in on the latest balance sheet data, we can see that NestlÃ© (Malaysia) Berhad had liabilities of RM 1.77 billion due within 12 months and liabilities of RM 465.1 million due beyond. In return, he had RM 24.8 million in cash and RM 389.4 million in receivables due within 12 months. He therefore has liabilities totaling RM 1.82 billion more than his cash and short-term receivables combined.
Considering that the listed NestlÃ© (Malaysia) Berhad shares are worth a total of RM31.1 billion, it seems unlikely that this level of liabilities is a major threat. However, we think it’s worth keeping an eye on the strength of its balance sheet as it can change over time. But in any case, NestlÃ© (Malaysia) Berhad has virtually no net debt, so it’s fair to say that she doesn’t have a lot of debt!
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). Thus, we look at debt versus earnings with and without amortization expenses.
With debt at 0.079x EBITDA and 25.1x interest-covering EBIT, it is clear that NestlÃ© (Malaysia) Berhad is not a desperate borrower. Compared to past profits, debt therefore seems insignificant. Fortunately, NestlÃ© (Malaysia) Berhad increased its EBIT by 5.3% over the past year, which makes this debt even more manageable. When analyzing debt levels, the balance sheet is the obvious place to start. But it is future profits, more than anything, that will determine NestlÃ© (Malaysia) Berhad’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only pay off its debts with hard cash, not with book profits. We must therefore clearly examine whether this EBIT leads to the corresponding free cash flow. Over the past three years, NestlÃ© (Malaysia) Berhad has recorded free cash flow of 76% of its EBIT, which is close to normal given that free cash flow excludes interest and taxes. This free cash flow puts the business in a good position to repay debt, if any.
Our point of view
The good news is that NestlÃ© (Malaysia) Berhad’s demonstrated ability to cover interest costs with EBIT thrills us like a fluffy puppy does a toddler. And the good news does not end there, since its net debt to EBITDA also supports this impression! Overall, we think NestlÃ© (Malaysia) Berhad’s use of debt looks very reasonable and we are not worried about it. After all, reasonable leverage can increase returns on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 1 warning sign for NestlÃ© (Malaysia) Berhad which you need to know before investing here.
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.
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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 any stock 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 material. Simply Wall St has no position in any of the stocks mentioned.