Is Steed Oriental (Holdings) (HKG:8277) Using Too Much 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.' 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 Steed Oriental (Holdings) Company Limited (HKG:8277) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Steed Oriental (Holdings)

What Is Steed Oriental (Holdings)'s Net Debt?

The chart below, which you can click on for greater detail, shows that Steed Oriental (Holdings) had HK$160.4m in debt in September 2023; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Steed Oriental (Holdings)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Steed Oriental (Holdings) had liabilities of HK$123.7m due within 12 months and liabilities of HK$110.7m due beyond that. Offsetting these obligations, it had cash of HK$735.0k as well as receivables valued at HK$22.5m due within 12 months. So its liabilities total HK$211.2m more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$34.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Steed Oriental (Holdings) would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Weak interest cover of 0.21 times and a disturbingly high net debt to EBITDA ratio of 73.6 hit our confidence in Steed Oriental (Holdings) like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. One redeeming factor for Steed Oriental (Holdings) is that it turned last year's EBIT loss into a gain of HK$3.1m, over the last twelve months. 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 Steed Oriental (Holdings) will need earnings to service that debt. 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Steed Oriental (Holdings) saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Steed Oriental (Holdings)'s conversion of EBIT to free cash flow 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. Having said that, its ability to grow its EBIT isn't such a worry. We think the chances that Steed Oriental (Holdings) has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 5 warning signs for Steed Oriental (Holdings) (4 shouldn't be ignored) 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.