Is Lapco Holdings (HKG:8472) A Risky Investment?

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.' 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. As with many other companies Lapco Holdings Limited (HKG:8472) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Lapco Holdings

What Is Lapco Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Lapco Holdings had HK$91.0m of debt, an increase on HK$66.0m, over one year. On the flip side, it has HK$52.3m in cash leading to net debt of about HK$38.7m.

A Look At Lapco Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that Lapco Holdings had liabilities of HK$217.4m due within 12 months and liabilities of HK$15.8m due beyond that. Offsetting these obligations, it had cash of HK$52.3m as well as receivables valued at HK$161.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$19.7m.

Of course, Lapco Holdings has a market capitalization of HK$552.0m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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).

Lapco Holdings has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.8 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We also note that Lapco Holdings improved its EBIT from a last year's loss to a positive HK$12m. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Lapco Holdings will need earnings to service that debt. 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Lapco Holdings actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

The good news is that Lapco Holdings's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its interest cover has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Lapco Holdings can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that Lapco Holdings is showing 5 warning signs in our investment analysis , and 1 of those is potentially serious...

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. 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.
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