Is Luen Wong Group Holdings (HKG:8217) Using Debt Sensibly?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Luen Wong Group Holdings Limited (HKG:8217) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that 8217 is potentially overvalued!

What Is Luen Wong Group Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Luen Wong Group Holdings had HK$32.0m of debt in September 2022, down from HK$107.0m, one year before. But it also has HK$54.2m in cash to offset that, meaning it has HK$22.2m net cash.

How Healthy Is Luen Wong Group Holdings' Balance Sheet?

According to the balance sheet data, Luen Wong Group Holdings had liabilities of HK$63.9m due within 12 months, but no longer term liabilities. Offsetting this, it had HK$54.2m in cash and HK$62.7m in receivables that were due within 12 months. So it actually has HK$53.0m more liquid assets than total liabilities.

This surplus strongly suggests that Luen Wong Group Holdings has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Luen Wong Group Holdings has more cash than debt is arguably a good indication that it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Luen Wong Group Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Luen Wong Group Holdings had a loss before interest and tax, and actually shrunk its revenue by 30%, to HK$81m. That makes us nervous, to say the least.

So How Risky Is Luen Wong Group Holdings?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And we do note that Luen Wong Group Holdings had an earnings before interest and tax (EBIT) loss, over the last year. Indeed, in that time it burnt through HK$13m of cash and made a loss of HK$15m. Given it only has net cash of HK$22.2m, the company may need to raise more capital if it doesn't reach break-even soon. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. 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 example, we've discovered 2 warning signs for Luen Wong Group Holdings that you should be aware of before investing here.

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.