Is Polyfair Holdings (HKG:8532) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Polyfair Holdings Limited (HKG:8532) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Polyfair Holdings

What Is Polyfair Holdings's Debt?

As you can see below, at the end of March 2022, Polyfair Holdings had HK$117.7m of debt, up from HK$98.0m a year ago. Click the image for more detail. However, it also had HK$12.5m in cash, and so its net debt is HK$105.2m.

How Strong Is Polyfair Holdings' Balance Sheet?

According to the balance sheet data, Polyfair Holdings had liabilities of HK$184.7m due within 12 months, but no longer term liabilities. Offsetting this, it had HK$12.5m in cash and HK$178.0m in receivables that were due within 12 months. So it can boast HK$5.80m more liquid assets than total liabilities.

This short term liquidity is a sign that Polyfair Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 1.9 times and a disturbingly high net debt to EBITDA ratio of 13.5 hit our confidence in Polyfair Holdings like a one-two punch to the gut. The debt burden here is substantial. Notably, Polyfair Holdings's EBIT was pretty flat over the last year, which isn't ideal given the debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Polyfair 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Polyfair Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Both Polyfair Holdings's conversion of EBIT to free cash flow and its net debt to EBITDA were discouraging. But its not so bad at staying on top of its total liabilities. Taking the abovementioned factors together we do think Polyfair Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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 3 warning signs for Polyfair Holdings that you should be aware of before investing here.

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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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.