Stock Analysis

Best Pacific International Holdings (HKG:2111) Seems To Be Using A Lot Of Debt

SEHK:2111
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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Best Pacific International Holdings Limited (HKG:2111) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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, 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.

Check out our latest analysis for Best Pacific International Holdings

What Is Best Pacific International Holdings's Debt?

As you can see below, at the end of June 2020, Best Pacific International Holdings had HK$2.23b of debt, up from HK$2.06b a year ago. Click the image for more detail. On the flip side, it has HK$784.4m in cash leading to net debt of about HK$1.45b.

debt-equity-history-analysis
SEHK:2111 Debt to Equity History December 23rd 2020

How Strong Is Best Pacific International Holdings's Balance Sheet?

The latest balance sheet data shows that Best Pacific International Holdings had liabilities of HK$2.06b due within a year, and liabilities of HK$916.8m falling due after that. Offsetting these obligations, it had cash of HK$784.4m as well as receivables valued at HK$618.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.58b.

Given this deficit is actually higher than the company's market capitalization of HK$1.25b, we think shareholders really should watch Best Pacific International Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Best Pacific International 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 4.2 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. The bad news is that Best Pacific International Holdings saw its EBIT decline by 10% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Best Pacific International Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Best Pacific International Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Best Pacific International Holdings's level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its net debt to EBITDA is not so bad. Taking into account all the aforementioned factors, it looks like Best Pacific International Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 example, we've discovered 2 warning signs for Best Pacific International Holdings that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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