Hong Wei (Asia) Holdings (HKG:8191) Takes On Some Risk With Its Use Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hong Wei (Asia) Holdings Company Limited (HKG:8191) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Hong Wei (Asia) Holdings

How Much Debt Does Hong Wei (Asia) Holdings Carry?

The image below, which you can click on for greater detail, shows that at June 2022 Hong Wei (Asia) Holdings had debt of HK$364.2m, up from HK$272.6m in one year. On the flip side, it has HK$62.5m in cash leading to net debt of about HK$301.6m.

How Strong Is Hong Wei (Asia) Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hong Wei (Asia) Holdings had liabilities of HK$364.8m due within 12 months and liabilities of HK$136.5m due beyond that. Offsetting these obligations, it had cash of HK$62.5m as well as receivables valued at HK$72.1m due within 12 months. So its liabilities total HK$366.7m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$43.7m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Hong Wei (Asia) 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hong Wei (Asia) Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (5.3), and fairly weak interest coverage, since EBIT is just 0.82 times the interest expense. The debt burden here is substantial. However, it should be some comfort for shareholders to recall that Hong Wei (Asia) Holdings actually grew its EBIT by a hefty 529%, over the last 12 months. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Hong Wei (Asia) 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Hong Wei (Asia) Holdings recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Hong Wei (Asia) Holdings's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Hong Wei (Asia) Holdings's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. We've identified 4 warning signs with Hong Wei (Asia) Holdings (at least 3 which shouldn't be ignored) , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.