The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Wing Fung Group Asia Limited (HKG:8526) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Wing Fung Group Asia's Net Debt?
As you can see below, at the end of June 2020, Wing Fung Group Asia had HK$26.6m of debt, up from HK$6.45m a year ago. Click the image for more detail. On the flip side, it has HK$23.5m in cash leading to net debt of about HK$3.04m.
A Look At Wing Fung Group Asia's Liabilities
According to the last reported balance sheet, Wing Fung Group Asia had liabilities of HK$62.6m due within 12 months, and liabilities of HK$783.0k due beyond 12 months. On the other hand, it had cash of HK$23.5m and HK$120.0m worth of receivables due within a year. So it actually has HK$80.1m more liquid assets than total liabilities.
This luscious liquidity implies that Wing Fung Group Asia's balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. But either way, Wing Fung Group Asia has virtually no net debt, so it's fair to say it does not have a heavy debt load!
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).
Wing Fung Group Asia has a low net debt to EBITDA ratio of only 0.15. And its EBIT easily covers its interest expense, being 36.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While Wing Fung Group Asia doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wing Fung Group Asia's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wing Fung Group Asia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Wing Fung Group Asia's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. All these things considered, it appears that Wing Fung Group Asia can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Wing Fung Group Asia , and understanding them should be part of your investment process.
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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