CK Life Sciences Int'l. (Holdings) (HKG:775) Has A Somewhat Strained Balance Sheet

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that CK Life Sciences Int'l., (Holdings) Inc. (HKG:775) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for CK Life Sciences Int'l. (Holdings)

What Is CK Life Sciences Int'l. (Holdings)'s Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 CK Life Sciences Int'l. (Holdings) had debt of HK$5.34b, up from HK$4.81b in one year. However, it also had HK$609.6m in cash, and so its net debt is HK$4.73b.

How Strong Is CK Life Sciences Int'l. (Holdings)'s Balance Sheet?

We can see from the most recent balance sheet that CK Life Sciences Int'l. (Holdings) had liabilities of HK$4.07b falling due within a year, and liabilities of HK$2.55b due beyond that. Offsetting these obligations, it had cash of HK$609.6m as well as receivables valued at HK$1.13b due within 12 months. So it has liabilities totalling HK$4.88b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since CK Life Sciences Int'l. (Holdings) has a market capitalization of HK$9.03b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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 1.3 times and a disturbingly high net debt to EBITDA ratio of 13.7 hit our confidence in CK Life Sciences Int'l. (Holdings) like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, CK Life Sciences Int'l. (Holdings) saw its EBIT tank 54% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is CK Life Sciences Int'l. (Holdings)'s earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, CK Life Sciences Int'l. (Holdings)'s free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

To be frank both CK Life Sciences Int'l. (Holdings)'s interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We're quite clear that we consider CK Life Sciences Int'l. (Holdings) to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 4 warning signs for CK Life Sciences Int'l. (Holdings) (2 make us uncomfortable) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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