Kasen International Holdings (HKG:496) Has No Shortage Of Debt

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Kasen International Holdings Limited (HKG:496) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Kasen International Holdings

How Much Debt Does Kasen International Holdings Carry?

The chart below, which you can click on for greater detail, shows that Kasen International Holdings had CN¥880.6m in debt in December 2020; about the same as the year before. However, it does have CN¥297.7m in cash offsetting this, leading to net debt of about CN¥582.9m.

How Healthy Is Kasen International Holdings' Balance Sheet?

The latest balance sheet data shows that Kasen International Holdings had liabilities of CN¥2.21b due within a year, and liabilities of CN¥629.7m falling due after that. Offsetting these obligations, it had cash of CN¥297.7m as well as receivables valued at CN¥1.22b due within 12 months. So it has liabilities totalling CN¥1.33b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CN¥1.24b, we think shareholders really should watch Kasen 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 measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Kasen International Holdings's debt to EBITDA ratio (3.1) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Worse, Kasen International Holdings's EBIT was down 85% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Kasen International Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Kasen International Holdings reported free cash flow worth 7.8% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Kasen International Holdings's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. And even its conversion of EBIT to free cash flow fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Kasen International Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Kasen International Holdings , and understanding them should be part of your investment process.

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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