Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk'. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that King Fook Holdings Limited (HKG:280) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is King Fook Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 King Fook Holdings had HK$29.4m of debt, an increase on HK$42.8, over one year. But on the other hand it also has HK$205.3m in cash, leading to a HK$175.9m net cash position.
How Healthy Is King Fook Holdings's Balance Sheet?
The latest balance sheet data shows that King Fook Holdings had liabilities of HK$107.2m due within a year, and liabilities of HK$29.5m falling due after that. Offsetting these obligations, it had cash of HK$205.3m as well as receivables valued at HK$11.0m due within 12 months. So it can boast HK$79.6m more liquid assets than total liabilities.
It's good to see that King Fook Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that King Fook Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
It was also good to see that despite losing money on the EBIT line last year, King Fook Holdings turned things around in the last 12 months, delivering and EBIT of HK$8.4m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since King Fook Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. King Fook Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, King Fook Holdings actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While we empathize with investors who find debt concerning, you should keep in mind that King Fook Holdings has net cash of HK$175.9m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$51m, being 611% of its EBIT. So is King Fook Holdings's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - King Fook Holdings has 2 warning signs we think you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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