We Think Legend Strategy International Holdings Group (HKG:1355) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Legend Strategy International Holdings Group Company Limited (HKG:1355) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Legend Strategy International Holdings Group

What Is Legend Strategy International Holdings Group's 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.

A Look At Legend Strategy International Holdings Group's Liabilities

According to the last reported balance sheet, Legend Strategy International Holdings Group had liabilities of HK$81.6m due within 12 months, and liabilities of HK$147.8m due beyond 12 months. Offsetting this, it had HK$20.0m in cash and HK$548.0k in receivables that were due within 12 months. So it has liabilities totalling HK$209.0m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$136.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Legend Strategy International Holdings Group would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

While Legend Strategy International Holdings Group has a quite reasonable net debt to EBITDA multiple of 1.8, its interest cover seems weak, at 1.0. 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. We also note that Legend Strategy International Holdings Group improved its EBIT from a last year's loss to a positive HK$5.6m. 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 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, Legend Strategy International Holdings Group actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, Legend Strategy International Holdings Group's level of total liabilities left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that Legend Strategy International Holdings Group's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Legend Strategy International Holdings Group (of which 1 makes us a bit uncomfortable!) you should know about.

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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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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