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 Leoch International Technology Limited (HKG:842) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Leoch International Technology’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Leoch International Technology had CN¥2.49b of debt in June 2019, down from CN¥3.10b, one year before. However, because it has a cash reserve of CN¥696.5m, its net debt is less, at about CN¥1.79b.
How Healthy Is Leoch International Technology’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Leoch International Technology had liabilities of CN¥5.36b due within 12 months and liabilities of CN¥175.1m due beyond that. Offsetting this, it had CN¥696.5m in cash and CN¥2.17b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥2.67b.
This deficit casts a shadow over the CN¥734.8m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Leoch International Technology would probably need a major re-capitalization if its creditors were to demand repayment.
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).
While we wouldn’t worry about Leoch International Technology’s net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 1.2 times is a sign of high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Worse, Leoch International Technology’s EBIT was down 46% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Leoch International Technology can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Leoch International Technology recorded free cash flow of 46% of its EBIT, which is weaker than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Leoch International Technology’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Taking into account all the aforementioned factors, it looks like Leoch International Technology has too much debt. That sort of riskiness is ok for some, but it certainly doesn’t float our boat. Given our concerns about Leoch International Technology’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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