Legend Strategy International Holdings Group (HKG:1355) Use Of Debt Could Be Considered Risky

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 Legend Strategy International Holdings Group Company Limited (HKG:1355) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Legend Strategy International Holdings Group

What Is Legend Strategy International Holdings Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Legend Strategy International Holdings Group had HK$37.0m of debt, an increase on HK$15.0m, over one year. On the flip side, it has HK$20.0m in cash leading to net debt of about HK$17.1m.

How Strong Is Legend Strategy International Holdings Group's Balance Sheet?

The latest balance sheet data shows that Legend Strategy International Holdings Group had liabilities of HK$81.6m due within a year, and liabilities of HK$147.8m falling due after that. Offsetting this, it had HK$20.0m in cash and HK$787.0k in receivables that were due within 12 months. So its liabilities total HK$208.7m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$139.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Legend Strategy International Holdings Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Even though Legend Strategy International Holdings Group's debt is only 2.3, its interest cover is really very low at 0.79. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Notably, Legend Strategy International Holdings Group made a loss at the EBIT level, last year, but improved that to positive EBIT of HK$4.3m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Legend Strategy International Holdings Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Legend Strategy International Holdings Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Legend Strategy International Holdings Group's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Legend Strategy International Holdings Group 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. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Legend Strategy International Holdings Group (at least 2 which can't be ignored) , 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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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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