Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 KWG Group Holdings Limited (HKG:1813) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is KWG Group Holdings’s Debt?
As you can see below, at the end of December 2018, KWG Group Holdings had CN¥77.5b of debt, up from CN¥59.6b a year ago. Click the image for more detail. However, it also had CN¥56.5b in cash, and so its net debt is CN¥21.0b.
How Strong Is KWG Group Holdings’s Balance Sheet?
We can see from the most recent balance sheet that KWG Group Holdings had liabilities of CN¥90.7b falling due within a year, and liabilities of CN¥62.1b due beyond that. On the other hand, it had cash of CN¥56.5b and CN¥1.12b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥95.2b.
This deficit casts a shadow over the CN¥17.1b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, KWG Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
KWG Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (27.6), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. The debt burden here is substantial. Even worse, KWG Group Holdings saw its EBIT tank 74% over the last 12 months. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if KWG Group 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, KWG Group Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, KWG Group Holdings’s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. It looks to us like KWG Group Holdings carries a significant balance sheet burden. If you harvest honey without a bee suit, you risk getting stung, so we’d probably stay away from this particular stock. Given our concerns about KWG Group Holdings’s debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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