Here's Why CK Life Sciences Int'l. (Holdings) (HKG:775) Can Manage Its Debt Responsibly

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that CK Life Sciences Int'l., (Holdings) Inc. (HKG:775) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 step when considering a company's debt levels is to consider its cash and debt together.

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

How Much Debt Does CK Life Sciences Int'l. (Holdings) Carry?

As you can see below, CK Life Sciences Int'l. (Holdings) had HK$5.62b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$858.8m in cash leading to net debt of about HK$4.77b.

A Look At CK Life Sciences Int'l. (Holdings)'s Liabilities

The latest balance sheet data shows that CK Life Sciences Int'l. (Holdings) had liabilities of HK$2.00b due within a year, and liabilities of HK$5.09b falling due after that. Offsetting this, it had HK$858.8m in cash and HK$930.6m in receivables that were due within 12 months. So its liabilities total HK$5.31b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$6.25b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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 2.0 times and a disturbingly high net debt to EBITDA ratio of 13.4 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. However, it should be some comfort for shareholders to recall that CK Life Sciences Int'l. (Holdings) actually grew its EBIT by a hefty 291%, 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. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since CK Life Sciences Int'l. (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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, CK Life Sciences Int'l. (Holdings) actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

CK Life Sciences Int'l. (Holdings)'s net debt to EBITDA was a real negative on this analysis, as was its interest cover. But like a ballerina ending on a perfect pirouette, it has not trouble converting EBIT to free cash flow. When we consider all the factors mentioned above, we do feel a bit cautious about CK Life Sciences Int'l. (Holdings)'s use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for CK Life Sciences Int'l. (Holdings) you should be aware of, and 2 of them are a bit unpleasant.

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.