OKG Technology Holdings (HKG:1499) Takes On Some Risk With Its Use Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, OKG Technology Holdings Limited (HKG:1499) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for OKG Technology Holdings

What Is OKG Technology Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 OKG Technology Holdings had HK$591.5m of debt, an increase on HK$97.6m, over one year. However, it also had HK$98.7m in cash, and so its net debt is HK$492.9m.

A Look At OKG Technology Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that OKG Technology Holdings had liabilities of HK$1.31b due within 12 months and liabilities of HK$4.23m due beyond that. On the other hand, it had cash of HK$98.7m and HK$104.5m worth of receivables due within a year. So it has liabilities totalling HK$1.11b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$1.34b, so it does suggest shareholders should keep an eye on OKG Technology Holdings' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

With a net debt to EBITDA ratio of 12.8, it's fair to say OKG Technology Holdings does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 6.6 times, suggesting it can responsibly service its obligations. We also note that OKG Technology Holdings improved its EBIT from a last year's loss to a positive HK$27m. There's no doubt that we learn most about debt from the balance sheet. But it is OKG Technology Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, OKG Technology Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both OKG Technology Holdings's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We're quite clear that we consider OKG Technology 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with OKG Technology Holdings , and understanding them should be part of your investment process.

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.

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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.