Is Kontafarma China Holdings (HKG:1312) 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. We can see that Kontafarma China Holdings Limited (HKG:1312) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Kontafarma China Holdings

What Is Kontafarma China Holdings's Debt?

The image below, which you can click on for greater detail, shows that Kontafarma China Holdings had debt of HK$200.5m at the end of June 2022, a reduction from HK$293.4m over a year. However, it also had HK$153.2m in cash, and so its net debt is HK$47.3m.

A Look At Kontafarma China Holdings' Liabilities

We can see from the most recent balance sheet that Kontafarma China Holdings had liabilities of HK$743.2m falling due within a year, and liabilities of HK$436.4m due beyond that. Offsetting these obligations, it had cash of HK$153.2m as well as receivables valued at HK$391.2m due within 12 months. So it has liabilities totalling HK$635.2m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$245.9m 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. After all, Kontafarma China Holdings would likely require a major re-capitalisation if it had to pay its creditors today. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Kontafarma China 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.

Over 12 months, Kontafarma China Holdings reported revenue of HK$1.0b, which is a gain of 9.4%, although it did not report any earnings before interest and tax. We usually like to see faster growth from unprofitable companies, but each to their own.

Caveat Emptor

Over the last twelve months Kontafarma China Holdings produced an earnings before interest and tax (EBIT) loss. Its EBIT loss was a whopping HK$34m. Combining this information with the significant liabilities we already touched on makes us very hesitant about this stock, to say the least. That said, it is possible that the company will turn its fortunes around. Nevertheless, we would not bet on it given that it vaporized HK$6.3m in cash over the last twelve months, and it doesn't have much by way of liquid assets. So we consider this a high risk stock and we wouldn't be at all surprised if the company asks shareholders for money before long. 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. To that end, you should be aware of the 3 warning signs we've spotted with Kontafarma China Holdings .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.