Health Check: How Prudently Does Hop Fung Group Holdings (HKG:2320) Use Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Hop Fung Group Holdings Limited (HKG:2320) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Hop Fung Group Holdings

What Is Hop Fung Group Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that Hop Fung Group Holdings had debt of HK$53.1m at the end of June 2023, a reduction from HK$145.6m over a year. But it also has HK$55.2m in cash to offset that, meaning it has HK$2.06m net cash.

A Look At Hop Fung Group Holdings' Liabilities

According to the last reported balance sheet, Hop Fung Group Holdings had liabilities of HK$109.9m due within 12 months, and liabilities of HK$62.1m due beyond 12 months. On the other hand, it had cash of HK$55.2m and HK$45.4m worth of receivables due within a year. So it has liabilities totalling HK$71.4m more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$71.1m, we think shareholders really should watch Hop Fung Group 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. Hop Fung Group Holdings boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hop Fung Group 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.

In the last year Hop Fung Group Holdings had a loss before interest and tax, and actually shrunk its revenue by 51%, to HK$289m. That makes us nervous, to say the least.

So How Risky Is Hop Fung Group Holdings?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And the fact is that over the last twelve months Hop Fung Group Holdings lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of HK$3.6m and booked a HK$169m accounting loss. Given it only has net cash of HK$2.06m, the company may need to raise more capital if it doesn't reach break-even soon. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. 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. For instance, we've identified 3 warning signs for Hop Fung Group Holdings (2 are potentially serious) you should be aware of.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.