Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.
What Is K. Wah International Holdings's Debt?
The image below, which you can click on for greater detail, shows that at June 2020 K. Wah International Holdings had debt of HK$19.5b, up from HK$17.1b in one year. However, because it has a cash reserve of HK$6.43b, its net debt is less, at about HK$13.0b.
How Strong Is K. Wah International Holdings's Balance Sheet?
According to the last reported balance sheet, K. Wah International Holdings had liabilities of HK$8.30b due within 12 months, and liabilities of HK$20.5b due beyond 12 months. On the other hand, it had cash of HK$6.43b and HK$1.02b worth of receivables due within a year. So its liabilities total HK$21.3b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$11.9b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, K. Wah International Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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). 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 to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. If K. Wah International Holdings can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine K. Wah International Holdings's ability to maintain a healthy balance sheet going forward. 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 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, K. Wah International Holdings's free cash flow amounted to 21% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over K. Wah International Holdings's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making K. Wah International Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that K. Wah International Holdings is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...
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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