We Think Kingworld Medicines Group (HKG:1110) Can Stay On Top Of Its 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 Kingworld Medicines Group Limited (HKG:1110) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Kingworld Medicines Group

What Is Kingworld Medicines Group's Debt?

As you can see below, at the end of June 2020, Kingworld Medicines Group had CN¥394.0m of debt, up from CN¥270.0m a year ago. Click the image for more detail. However, it also had CN¥275.9m in cash, and so its net debt is CN¥118.1m.

How Strong Is Kingworld Medicines Group's Balance Sheet?

We can see from the most recent balance sheet that Kingworld Medicines Group had liabilities of CN¥648.2m falling due within a year, and liabilities of CN¥25.5m due beyond that. Offsetting this, it had CN¥275.9m in cash and CN¥247.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥149.9m more than its cash and near-term receivables, combined.

Kingworld Medicines Group has a market capitalization of CN¥409.1m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Kingworld Medicines Group's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 14.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Kingworld Medicines Group saw its EBIT drop by 6.8% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Kingworld Medicines Group 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Kingworld Medicines Group recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Kingworld Medicines Group's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. It's also worth noting that Kingworld Medicines Group is in the Healthcare industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Kingworld Medicines Group is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Be aware that Kingworld Medicines Group is showing 5 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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