Is Ko Yo Chemical (Group) (HKG:827) Using Debt Sensibly?

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.' 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. Importantly, Ko Yo Chemical (Group) Limited (HKG:827) does carry debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Ko Yo Chemical (Group)

What Is Ko Yo Chemical (Group)'s Debt?

The image below, which you can click on for greater detail, shows that Ko Yo Chemical (Group) had debt of CN¥2.12b at the end of June 2020, a reduction from CN¥2.22b over a year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is Ko Yo Chemical (Group)'s Balance Sheet?

According to the last reported balance sheet, Ko Yo Chemical (Group) had liabilities of CN¥1.91b due within 12 months, and liabilities of CN¥862.6m due beyond 12 months. Offsetting this, it had CN¥6.42m in cash and CN¥48.2m in receivables that were due within 12 months. So its liabilities total CN¥2.72b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CN¥333.3m 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. At the end of the day, Ko Yo Chemical (Group) would probably need a major re-capitalization if its creditors were to demand repayment. When analysing debt levels, the balance sheet is the obvious place to start. But it is Ko Yo Chemical (Group)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

In the last year Ko Yo Chemical (Group) had a loss before interest and tax, and actually shrunk its revenue by 2.7%, to CN¥2.0b. That's not what we would hope to see.

Caveat Emptor

Importantly, Ko Yo Chemical (Group) had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable CN¥140m at the EBIT level. When you combine this with the very significant balance sheet liabilities mentioned above, we are so wary of it that we are basically at a loss for the right words. Like every long-shot we're sure it has a glossy presentation outlining its blue-sky potential. But the reality is that it is low on liquid assets relative to liabilities, and it lost CN¥507m in the last year. So we're not very excited about owning this stock. Its too risky for us. 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. For instance, we've identified 3 warning signs for Ko Yo Chemical (Group) (1 is a bit concerning) you should be aware of.

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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