Howard Marks put it nicely when he said that instead of worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about … and every practical investor I know is concerned about.” , worrying.” It’s only natural to consider a company’s balance sheet when examining how risky it is, since debt is often at play when a company fails. We can see that HKC (Holdings) Limited (HKG:190) uses debt in his business. But the real question is whether that debt makes the company risky.
What is the risk of debt?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it’s at their mercy. An integral part of capitalism is the process of “creative destruction,” in which failed companies are mercilessly liquidated by their bankers. While not all that common, we often see leveraged companies permanently diluting shareholders as lenders force them to raise capital at a distressed price. However, the most common situation is that a company is managing its debt reasonably well — and for its own benefit. When examining debt, let’s first look at both cash and debt together.
How Much Debt Does HKC (Holdings) Have?
You can click on the graph below to see historical numbers, but it shows that HKC (Holdings) had HK$3.49 billion in debt in December 2020, an increase of HK$3.17 billion corresponds to more than one year. However, it has HK$1.32 billion in cash, which offsets this, resulting in a net debt of about HK$2.17 billion.
How strong is HKC (Holdings) balance sheet?
The latest balance sheet data shows that HKC (Holdings) had HK$2.31 billion in debt maturing within one year and HK$4.25 billion in debt maturing thereafter. On the other hand, it had HK$1.32 billion in cash and HK$645.7 million in receivables due within one year. So its liabilities are HK$4.59 billion more than the combination of cash and short-term receivables.
Considering that this shortfall exceeds the company’s market capitalization of HK$3.89 billion, one might be tempted to examine the balance sheet closely. Hypothetically, extremely strong dilution would be required if the company were forced to pay its debt by raising capital at the current share price.
We measure a company’s debt burden relative to its profitability by dividing its net debt by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how well its earnings before interest and taxes (EBIT) cover its interest costs (interest coverage) . In this way, we take into account both the absolute amount of the debt and the interest paid on it.
HKC (Holdings) debt is 3.3 times its EBITDA and its EBIT covers its interest expenses 3.0 times more. This suggests that while the leverage is significant, we wouldn’t call it problematic. One redeeming factor, however, is that HKC (Holdings) grew its EBIT by 16% over the trailing 12 months, improving its ability to manage its debt. Undoubtedly, we learn most about debt from the balance sheet. But you can’t look at debt entirely in isolation; as HKC (Holdings) needs revenue to service this debt. So when looking at debt, it’s definitely worth looking at earnings performance. Click here for an interactive snapshot.
After all, a business needs free cash flow to pay off debt; Accounting profits just don’t cut it. So we really need to see if that EBIT translates into free cash flow to match. Over the past three years, HKC (Holdings) has generated solid free cash flow that is 80% of its EBIT, which is roughly in line with our expectations. This cold, hard money means they can reduce their debt whenever they want.
The level of total debt and interest coverage of HKC (Holdings) is definitely weighing on them in our view. But the good news is that converting EBIT to free cash flow appears to be fairly straightforward. Having considered the above data points together, we think HKC (Holdings) debt makes it a bit risky. That’s not necessarily a bad thing, since leverage can increase return on equity, but it’s something to be aware of. Undoubtedly, we learn most about debt from the balance sheet. But ultimately, any business can have off-balance-sheet risks. For example, we have identified 4 Warning Signs for HKC (Holdings) that you should be aware of.
After all this, if you’re more interested in a fast-growing company with a rock-solid balance sheet, then look no further our list of net cash growth stocks without delay.
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