These 4 Measures Indicate That L.K. Technology Holdings (HKG:558) Is Using Debt Extensively

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, 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?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for L.K. Technology Holdings

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

The image below, which you can click on for greater detail, shows that L.K. Technology Holdings had debt of HK$1.43b at the end of September 2020, a reduction from HK$1.73b over a year. On the flip side, it has HK$588.5m in cash leading to net debt of about HK$846.1m.

How Healthy Is L.K. Technology Holdings's Balance Sheet?

The latest balance sheet data shows that L.K. Technology Holdings had liabilities of HK$2.90b due within a year, and liabilities of HK$65.8m falling due after that. Offsetting this, it had HK$588.5m in cash and HK$1.49b in receivables that were due within 12 months. So its liabilities total HK$893.1m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$1.44b, so it does suggest shareholders should keep an eye on L.K. Technology Holdings's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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's debt is 2.5 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that L.K. Technology Holdings's EBIT shot up like bamboo after rain, gaining 40% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is L.K. Technology Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Considering the last three years, L.K. Technology Holdings actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

L.K. Technology Holdings's conversion of EBIT to free cash flow and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that L.K. Technology Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 3 warning signs we've spotted with L.K. Technology Holdings (including 1 which is is a bit concerning) .

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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