Is KuangChi Science (HKG:439) Using Debt In A Risky Way?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, KuangChi Science Limited (HKG:439) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that 439 is potentially undervalued!

What Is KuangChi Science's Debt?

The image below, which you can click on for greater detail, shows that KuangChi Science had debt of HK$158.6m at the end of June 2022, a reduction from HK$180.9m over a year. But it also has HK$243.1m in cash to offset that, meaning it has HK$84.5m net cash.

A Look At KuangChi Science's Liabilities

The latest balance sheet data shows that KuangChi Science had liabilities of HK$139.7m due within a year, and liabilities of HK$264.5m falling due after that. Offsetting this, it had HK$243.1m in cash and HK$55.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$106.1m.

Given KuangChi Science has a market capitalization of HK$837.3m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, KuangChi Science boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But it is KuangChi Science's earnings that will influence how the balance sheet holds up in the future. 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.

Over 12 months, KuangChi Science reported revenue of HK$131m, which is a gain of 151%, although it did not report any earnings before interest and tax. So its pretty obvious shareholders are hoping for more growth!

So How Risky Is KuangChi Science?

While KuangChi Science lost money on an earnings before interest and tax (EBIT) level, it actually generated positive free cash flow HK$157m. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. The good news for KuangChi Science shareholders is that its revenue growth is strong, making it easier to raise capital if need be. But that doesn't change our opinion that the stock is risky. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - KuangChi Science has 1 warning sign we think you should be aware of.

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. 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.