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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Ching Lee Holdings Limited (HKG:3728) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Ching Lee Holdings
How Much Debt Does Ching Lee Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Ching Lee Holdings had HK$156.2m of debt in September 2020, down from HK$201.4m, one year before. However, it also had HK$118.3m in cash, and so its net debt is HK$38.0m.
How Strong Is Ching Lee Holdings's Balance Sheet?
We can see from the most recent balance sheet that Ching Lee Holdings had liabilities of HK$386.5m falling due within a year, and liabilities of HK$3.36m due beyond that. Offsetting these obligations, it had cash of HK$118.3m as well as receivables valued at HK$315.8m due within 12 months. So it actually has HK$44.2m more liquid assets than total liabilities.
It's good to see that Ching Lee Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Ching Lee Holdings has a quite reasonable net debt to EBITDA multiple of 2.1, its interest cover seems weak, at 1.9. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Sadly, Ching Lee Holdings's EBIT actually dropped 7.5% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Ching Lee Holdings will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Ching Lee Holdings recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Our View
Ching Lee Holdings's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its level of total liabilities was a positive. Looking at all this data makes us feel a little cautious about Ching Lee Holdings's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 6 warning signs for Ching Lee Holdings (2 shouldn't be ignored!) that you should be aware of before investing here.
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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About SEHK:3728
Ching Lee Holdings
An investment holding company, engages in the provision of construction, consultancy, and project management services primarily in Hong Kong.
Mediocre balance sheet and slightly overvalued.