The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that CK Hutchison Holdings Limited (HKG:1) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does CK Hutchison Holdings Carry?
The chart below, which you can click on for greater detail, shows that CK Hutchison Holdings had HK$354.4b in debt in June 2021; about the same as the year before. However, it also had HK$182.2b in cash, and so its net debt is HK$172.2b.
A Look At CK Hutchison Holdings' Liabilities
According to the last reported balance sheet, CK Hutchison Holdings had liabilities of HK$194.5b due within 12 months, and liabilities of HK$418.3b due beyond 12 months. Offsetting this, it had HK$182.2b in cash and HK$35.8b in receivables that were due within 12 months. So its liabilities total HK$394.9b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$202.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, CK Hutchison Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
CK Hutchison Holdings has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.3 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Another concern for investors might be that CK Hutchison Holdings's EBIT fell 18% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine CK Hutchison 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, CK Hutchison Holdings produced sturdy free cash flow equating to 78% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On the face of it, CK Hutchison Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We're quite clear that we consider CK Hutchison Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. For instance, we've identified 3 warning signs for CK Hutchison Holdings that 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.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 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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