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 note that Lonking Holdings Limited (HKG:3339) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Lonking Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Lonking Holdings had CN¥663.5m of debt in December 2020, down from CN¥709.3m, one year before. But on the other hand it also has CN¥4.53b in cash, leading to a CN¥3.87b net cash position.
How Strong Is Lonking Holdings' Balance Sheet?
The latest balance sheet data shows that Lonking Holdings had liabilities of CN¥7.10b due within a year, and liabilities of CN¥84.7m falling due after that. Offsetting this, it had CN¥4.53b in cash and CN¥3.36b in receivables that were due within 12 months. So it can boast CN¥714.7m more liquid assets than total liabilities.
This short term liquidity is a sign that Lonking Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Lonking Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
Fortunately, Lonking Holdings grew its EBIT by 9.0% in the last year, making that debt load look even more manageable. 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 Lonking Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Lonking 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. In the last three years, Lonking Holdings's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that Lonking Holdings has net cash of CN¥3.87b, as well as more liquid assets than liabilities. And it also grew its EBIT by 9.0% over the last year. So is Lonking Holdings's debt a risk? It doesn't seem so to us. 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. Case in point: We've spotted 3 warning signs for Lonking Holdings you should be aware of, and 1 of them is a bit unpleasant.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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