Is L.K. Technology Holdings (HKG:558) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. Importantly, L.K. Technology Holdings Limited (HKG:558) does carry debt. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for L.K. Technology Holdings

How Much Debt Does L.K. Technology Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that L.K. Technology Holdings had HK$1.17b of debt in March 2021, down from HK$1.77b, one year before. However, it does have HK$601.2m in cash offsetting this, leading to net debt of about HK$564.3m.

How Strong Is L.K. Technology Holdings' Balance Sheet?

We can see from the most recent balance sheet that L.K. Technology Holdings had liabilities of HK$2.81b falling due within a year, and liabilities of HK$209.3m due beyond that. Offsetting this, it had HK$601.2m in cash and HK$1.59b in receivables that were due within 12 months. So it has liabilities totalling HK$826.0m more than its cash and near-term receivables, combined.

Since publicly traded L.K. Technology Holdings shares are worth a total of HK$20.0b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). 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).

L.K. Technology Holdings has a low net debt to EBITDA ratio of only 0.92. And its EBIT covers its interest expense a whopping 10.7 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, L.K. Technology Holdings grew its EBIT by 249% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine L.K. Technology 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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, L.K. Technology Holdings basically broke even on a free cash flow basis. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

Happily, L.K. Technology Holdings's impressive EBIT growth rate implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Taking all this data into account, it seems to us that L.K. Technology Holdings takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. 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 - L.K. Technology Holdings has 3 warning signs we think 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.

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