Here's Why Wang On Group (HKG:1222) Is Weighed Down By Its Debt Load

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Wang On Group Limited (HKG:1222) does carry debt. But should shareholders be worried about its use of debt?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Wang On Group

What Is Wang On Group's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Wang On Group had debt of HK$6.62b, up from HK$5.62b in one year. However, it also had HK$1.98b in cash, and so its net debt is HK$4.64b.

How Strong Is Wang On Group's Balance Sheet?

The latest balance sheet data shows that Wang On Group had liabilities of HK$5.06b due within a year, and liabilities of HK$5.60b falling due after that. Offsetting these obligations, it had cash of HK$1.98b as well as receivables valued at HK$680.7m due within 12 months. So it has liabilities totalling HK$7.99b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$1.07b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Wang On Group would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Wang On Group shareholders face the double whammy of a high net debt to EBITDA ratio (16.1), and fairly weak interest coverage, since EBIT is just 0.88 times the interest expense. The debt burden here is substantial. Worse, Wang On Group's EBIT was down 71% over the last year. 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Wang On Group's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Wang On Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Wang On Group's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that Wang On Group is carrying heavy debt load. If you harvest honey without a bee suit, you risk getting stung, so we'd probably stay away from this particular stock. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Wang On Group you should be aware of, and 2 of them are significant.

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. 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.
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