Best Pacific International Holdings (HKG:2111) Takes On Some Risk With Its Use Of Debt

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. We can see that Best Pacific International Holdings Limited (HKG:2111) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Best Pacific International Holdings

What Is Best Pacific International Holdings's Debt?

As you can see below, Best Pacific International Holdings had HK$2.29b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of HK$1.10b, its net debt is less, at about HK$1.19b.

A Look At Best Pacific International Holdings' Liabilities

According to the last reported balance sheet, Best Pacific International Holdings had liabilities of HK$2.22b due within 12 months, and liabilities of HK$1.08b due beyond 12 months. Offsetting this, it had HK$1.10b in cash and HK$917.2m in receivables that were due within 12 months. So its liabilities total HK$1.29b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$1.90b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

Best Pacific International Holdings's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 5.1 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Sadly, Best Pacific International Holdings's EBIT actually dropped 9.7% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Best Pacific International Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into 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

Mulling over Best Pacific International Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Overall, we think it's fair to say that Best Pacific International Holdings has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. We've identified 3 warning signs with Best Pacific International Holdings , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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