Far East Holdings International (HKG:36) Use Of Debt Could Be Considered Risky

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.' 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. As with many other companies Far East Holdings International Limited (HKG:36) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Far East Holdings International

How Much Debt Does Far East Holdings International Carry?

As you can see below, Far East Holdings International had HK$612.9m of debt at June 2022, down from HK$650.0m a year prior. However, it does have HK$12.5m in cash offsetting this, leading to net debt of about HK$600.4m.

How Strong Is Far East Holdings International's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Far East Holdings International had liabilities of HK$620.4m due within 12 months and no liabilities due beyond that. Offsetting this, it had HK$12.5m in cash and HK$3.36m in receivables that were due within 12 months. So it has liabilities totalling HK$604.5m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$125.2m 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, Far East Holdings International 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.04 times and a disturbingly high net debt to EBITDA ratio of 539 hit our confidence in Far East Holdings International like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Even worse, Far East Holdings International saw its EBIT tank 98% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Far East Holdings International's earnings that will influence how the balance sheet holds up in the future. 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. Over the last three years, Far East Holdings International actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Far East Holdings International'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 converting EBIT to free cash flow; that's encouraging. After considering the datapoints discussed, we think Far East Holdings International has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. 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. For instance, we've identified 4 warning signs for Far East Holdings International (2 can't be ignored) you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.