SUBUR 6904 SUBUR TIASA HOLDINGS BERHAD: Is debt good? When is it good? kcchongnz
This article is written purely for sharing purpose. It does not contain any malicious intention. It may even be a good advice.
“As at 31 December 2021, the Group’s current liabilities exceeded its current assets by RM393.8 million (2020: RM458.3 million). This condition gives rise to concerns about whether the Group has sufficient cash flows to meet its obligations for the next 12 months from the end of the reporting period, and whether the use of going concern basis in the preparation of the financial statements is appropriate.”
The above statement appears in the 2021 annual report of Subur Tiasa, a plantation company listed in Bursa Malaysia. It was an unmodified audit opinion with a material uncertainty related to the going concern over the audited financial statements for the financial period ended Dec 31, 2021, issued by the group's independent auditor Crowe Malaysia PLT.
Is that serious?
I read another statement in this blog, this time by an investor in Subur Tiasa below.
“Investors might be too concerned with the auditor’s opinion that the company’s current liabilities exceeded current assets. From my long experience in doing business, I usually like to borrow as much money as possible provided I know how to use the loan to make more profit. In fact, I always use margin finance to buy more shares to make more money.”
The above statement seems there is no issue at all on the current liabilities exceeding the current assets by RM394 million.
So, who’s opinion should we take, the independent auditor, or that of the blogger?
There seem to be some mix up in the above comment by the blogger. First, he talked about company borrowing money for doing business. Later he talked about personal borrowing, that he always uses margin finance to speculate in the stock market to make more money.
But are they the same, personal debts and corporate debts?
Personal debts are incurred by individuals for, well, personal uses. There are good personal debts and there are bad debts. Borrowing money by youngsters starting in their working life for buying a house or a normal car for work purpose, buying the first house or a student loan is okay as these are considered as “good debts”. Borrowing for a holiday, luxury goods which you have not earned, and hence incurred debts using credit cards are bad debts.
I had done all the above, good and bad debts, when I was young and first came out of university to work. From my personal experience, I would encourage the use of good debts but avoid bad debts.
One thing I have never borrowed money or using margin financing to speculate in the stock market. I am not as good as someone who “always use margin finance to buy more shares to make more money.”
But has he really been making more money using margin finance speculating in the stock market? I am not sure about that, are you?
What about corporate debt? Is it good?
Certainly, but to a certain extent and under certain conditions.
The main reason companies decide to go public is to raise money to do business, a lot of money from a large group of shareholders and debt holders such as banks and preference shareholders. Furthermore, a public listed status gives it a solid standing when negotiating interest rates with banks.
There are two major reasons why a company should use debt to finance a large portion of its business.
First, the government encourages businesses to use debt by allowing them to deduct the interest on the debt from corporate income taxes. With the corporate tax rate at 24% in Malaysia, that deduction is quite enticing, reducing the after-tax cost of debt to be below five percent after considering the tax break associated with interest.
Second, debt is a much cheaper form of financing than equity. It starts with the fact that equity is riskier than debt. Because a company typically has no legal obligation to pay dividends to common shareholders, those shareholders want a certain rate of return. Debt is much less risky for the investor and bankers because the firm is legally obligated to pay it. In addition, shareholders are the first to lose their investments when a firm goes bankrupt. Finally, much of the return on equity is tied up in stock appreciation, which requires a company to grow revenue, profit and cash flow. An investor typically wants at least a 10% return due to these risks and uncertainties, while debt can usually be found at a lower rate, say may be 6%.
So, using debts for a good business enhances the return of equity shareholders. It is unwise for companies not to use debts to do business.
Then why not finance a business entirely with debts?
This is because all debt, or even 80% debt, would be too risky to those providing the financing. During an economic crisis, even a good company can get into trouble and go bankrupt. Hence, if the debt increases, it is riskier. Equity and debt holders or banks will require higher returns.
A business needs to balance the use of debt and equity to keep the average cost of capital, WACC at its minimum.
Figure below depicts the theoretical cost of capital with the rise of debt, or financial leverage. It shows how the cost of equity and debt, and hence WACC, rise sharply after a certain level of leverage, because of the rise in bankruptcy risk as debts go up.
In investing in stocks, investors have to watch out that the debt of the company he invests in is not excessive such that the company is not able to fulfill its obligations and go belly up. That is especially true in times of financial and economic crisis.
But how much debts are excessive? It is best to view this from the point of angle from bankers.
Let us use the balance sheet of Subur Tiasa, a stock aggressively promoted in i3investor as an example.
How much skin (capital) shareholders have in the business?
The company’s capital provided by shareholders is measured as a percentage of its total investment cost and lenders want to see that shareholders have adequate “skin in the game.” The more capital shareholders invest, the greater the commitment of the management to the success of the business. When your own money is involved, it serves as an incentive to not default on a loan. Obviously, the banks would prefer the equity of shareholders must be higher than the total loans the company is owing.
The latest balance sheet of Subur shows it has a total debt of RM606 million as compared to the total equity of RMRM627 million. This is somewhat marginal and probably inadequate in the eyes of banks.
Banks may refer to its market value of its equity, the market cap of Subur Tiasa to assess the adequacy of share of capital by shareholders. At RM2.40 at the close on last Friday on 29 April 2022 and with 188.3m shares outstanding, the market cap is RM452 million. This MC is way below its total debts. Bankers would not feel comfortable with this.
Does the company have the capacity to pay interest and repay the loans according to the terms?
Bankers would want to ensure that the company’s cash flow allows for interest payment and repayment of the loan according to its terms.
In the last twelve months, operating profit of Subur was RM58.1 million, 4 times its interest cost for the year. That appears to be okay, but marginally. Its cash flows from operations were much higher at RM185 million. That was certainly okay to cover interest charges for the year. The banks may be comfortable with these.
But here comes the problems.
Subur has a total short-term loan of RM425 million. Short-term loan, by definition, must pay up within a year. In the last twelve months ended 31 December 2021, its net profit was RM55.8 million, which was only 13% of its short-term debts. Cash flows from operations were much better at RM126.5 million. But that was also far short of the RM452 million short-term debts.
So, it is obvious that Subur will not be able to fulfil its short-term debt repayment obligations.
The banks may not take any action detrimental to its operations as long as the palm price stays at the present elevated level, as its cash flows was adequate for interest payment. But that is the sole prerogative of the banks.
Net Working Capital
Net Working Capital (NWC) is defined as the difference between the current assets and current liabilities. Current assets are assets which can be sold and realized in cash. Current liabilities are what the company owed to banks and creditors which must be paid up within a year.
Net working capital = Current assets – current liabilities
Obviously, a company must have more current assets than current liabilities so that it can fulfil its short-term obligations to pay banks and creditors when demanded, or NWC must be positive.
In its latest balance sheet, Subur had current assets of RM147.4 million as opposed to its current liabilities of RM549.2 million.
NWC = 147.4 – 549.2 = -402 million
That was the gist of the auditor’s “unmodified audit opinion” mentioned above.
This also gives rise to the liquidity issue that the current ratio is way below the required 1.5.
Current ratio = 147.4 / 549.2 = 0.3
That is way below the norm of minimum of 1.5.
This final variable pertains to the economy. Factors outside of the control of the management, such as any economic downturn or financial crisis– in general or specifically within the industry – or the bank already having many loans within the same industry, may result in the bank recalling the loan because of a higher risk.
With Ukraine war, high inflation and Fed raising interest in such a manner, the economic and financial conditions of the country as well as the world is surely not that rosy as now.
It is much better to invest companies with healthier balance sheet as a safety measure. There are certainly many companies in the plantation sector with much healthier balance sheet and lower risk of bankruptcy, and cheaper in valuations when the correct valuation metrics are used as shown in my last article posted in this blog.
Why would you want to invest in a not-so-cheap company with unmodified audit opinion with a material uncertainty related to the going concern over the audited financial statements, and risk losing all your money, when there are so many other better choices?
Personal debts are good if they are used for buying good assets such as a first house and car for work, but not good for luxurious consumptions. Corporate debts are often necessary for companies doing business. Debts are very good for a company if it is able to make much higher return from its cost of borrowings. However, debt is evil for a company which is unable to earn enough even to cover its interest and capital repayment in the long and short-term.
Subur’s balance sheet is precarious to say the least. It is at the mercy of the lenders whether to extend its short-term loans. I foresee that a round of private placement or a rights issue is on the card, very soon in order for it just to keep its doors opened.
If you do not wish to risk losing your money (again), pay attention, a lot of attention, to the balance sheet of the company too.
This is a friendly advice.
K C Chong