We Think K. Wah International Holdings (HKG:173) Is Taking Some Risk With Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, K. Wah International Holdings Limited (HKG:173) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 K. Wah International Holdings

What Is K. Wah International Holdings's Debt?

The image below, which you can click on for greater detail, shows that K. Wah International Holdings had debt of HK$14.9b at the end of December 2022, a reduction from HK$19.0b over a year. However, it does have HK$8.82b in cash offsetting this, leading to net debt of about HK$6.12b.

How Strong Is K. Wah International Holdings' Balance Sheet?

The latest balance sheet data shows that K. Wah International Holdings had liabilities of HK$15.1b due within a year, and liabilities of HK$14.9b falling due after that. Offsetting this, it had HK$8.82b in cash and HK$1.11b in receivables that were due within 12 months. So it has liabilities totalling HK$20.1b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the HK$8.30b 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'd watch its balance sheet closely, without a doubt. After all, K. Wah International Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

K. Wah International Holdings's net debt is 3.5 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense on the debt is currently quite low. Importantly, K. Wah International Holdings's EBIT fell a jaw-dropping 58% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if K. Wah International Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, K. Wah International Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

To be frank both K. Wah International Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Looking at the bigger picture, it seems clear to us that K. Wah International Holdings's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 example - K. Wah International Holdings has 1 warning sign we think 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. 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.