Hong Kong Johnson Holdings (HKG:1955) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hong Kong Johnson Holdings Co., Ltd. (HKG:1955) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

See our latest analysis for Hong Kong Johnson Holdings

What Is Hong Kong Johnson Holdings's Net Debt?

As you can see below, at the end of September 2020, Hong Kong Johnson Holdings had HK$422.8m of debt, up from HK$285.8m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$223.1m, its net debt is less, at about HK$199.8m.

How Healthy Is Hong Kong Johnson Holdings's Balance Sheet?

The latest balance sheet data shows that Hong Kong Johnson Holdings had liabilities of HK$741.7m due within a year, and liabilities of HK$45.4m falling due after that. Offsetting these obligations, it had cash of HK$223.1m as well as receivables valued at HK$757.8m due within 12 months. So it actually has HK$193.7m more liquid assets than total liabilities.

This luscious liquidity implies that Hong Kong Johnson Holdings's balance sheet is sturdy like a giant sequoia tree. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hong Kong Johnson Holdings's net debt of 1.8 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.6 times interest expense) certainly does not do anything to dispel this impression. Notably, Hong Kong Johnson Holdings's EBIT launched higher than Elon Musk, gaining a whopping 132% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Hong Kong Johnson Holdings'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.

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. During the last three years, Hong Kong Johnson Holdings burned a lot of cash. 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

Hong Kong Johnson Holdings's EBIT growth rate 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. Looking at the bigger picture, we think Hong Kong Johnson Holdings's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 4 warning signs for Hong Kong Johnson Holdings (2 shouldn't be ignored) you should be aware of.

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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This article by Simply Wall St is general in nature. 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.
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