Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. As with many other companies CK Asset Holdings Limited (HKG:1113) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is CK Asset Holdings’s Debt?
The image below, which you can click on for greater detail, shows that at June 2020 CK Asset Holdings had debt of HK$76.4b, up from HK$61.2b in one year. However, it also had HK$57.9b in cash, and so its net debt is HK$18.5b.
How Healthy Is CK Asset Holdings’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that CK Asset Holdings had liabilities of HK$53.6b due within 12 months and liabilities of HK$88.4b due beyond that. Offsetting these obligations, it had cash of HK$57.9b as well as receivables valued at HK$8.94b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$75.2b.
While this might seem like a lot, it is not so bad since CK Asset Holdings has a huge market capitalization of HK$154.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
CK Asset Holdings has a low debt to EBITDA ratio of only 0.59. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there’s no doubt this company can take on debt while staying cool as a cucumber. The good news is that CK Asset Holdings has increased its EBIT by 6.5% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine CK Asset Holdings’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, CK Asset Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, CK Asset Holdings’s impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like CK Asset Holdings is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with CK Asset Holdings , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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