Does K2 F&B Holdings (HKG:2108) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 note that K2 F&B Holdings Limited (HKG:2108) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for K2 F&B Holdings

How Much Debt Does K2 F&B Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 K2 F&B Holdings had S$74.3m of debt, an increase on S$56.2m, over one year. On the flip side, it has S$10.9m in cash leading to net debt of about S$63.4m.

A Look At K2 F&B Holdings' Liabilities

We can see from the most recent balance sheet that K2 F&B Holdings had liabilities of S$8.87m falling due within a year, and liabilities of S$71.6m due beyond that. Offsetting this, it had S$10.9m in cash and S$824.0k in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by S$68.7m.

The deficiency here weighs heavily on the S$31.5m 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 definitely think shareholders need to watch this one closely. After all, K2 F&B Holdings 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).

K2 F&B Holdings has a rather high debt to EBITDA ratio of 7.7 which suggests a meaningful debt load. However, its interest coverage of 4.6 is reasonably strong, which is a good sign. Pleasingly, K2 F&B Holdings is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 117% gain in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is K2 F&B Holdings'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 we always check how much of that EBIT is translated into free cash flow. Considering the last three years, K2 F&B Holdings actually recorded a cash outflow, overall. 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

On the face of it, K2 F&B Holdings's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that K2 F&B Holdings's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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 6 warning signs with K2 F&B Holdings (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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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