L.K. Technology Holdings (HKG:558) Has A Pretty Healthy Balance Sheet

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. We note that L.K. Technology Holdings Limited (HKG:558) does have debt on its balance sheet. 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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for L.K. Technology Holdings

What Is L.K. Technology Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 L.K. Technology Holdings had HK$1.48b of debt, an increase on HK$855.0m, over one year. On the flip side, it has HK$611.0m in cash leading to net debt of about HK$868.1m.

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$3.68b falling due within a year, and liabilities of HK$504.5m due beyond that. Offsetting these obligations, it had cash of HK$611.0m as well as receivables valued at HK$2.38b due within 12 months. So it has liabilities totalling HK$1.20b more than its cash and near-term receivables, combined.

Given L.K. Technology Holdings has a market capitalization of HK$10.6b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

L.K. Technology Holdings's net debt is only 1.0 times its EBITDA. And its EBIT covers its interest expense a whopping 24.6 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, L.K. Technology Holdings saw its EBIT drop by 4.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if L.K. Technology Holdings can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, L.K. Technology Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis L.K. Technology Holdings's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. Looking at all this data makes us feel a little cautious about L.K. Technology 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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for L.K. Technology Holdings that 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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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.