Is Lifestyle International Holdings (HKG:1212) A Risky Investment?

Warren Buffett famously said, '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, Lifestyle International Holdings Limited (HKG:1212) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Lifestyle International Holdings

What Is Lifestyle International Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Lifestyle International Holdings had HK$18.2b of debt, an increase on HK$16.2b, over one year. However, it does have HK$9.93b in cash offsetting this, leading to net debt of about HK$8.29b.

How Strong Is Lifestyle International Holdings's Balance Sheet?

We can see from the most recent balance sheet that Lifestyle International Holdings had liabilities of HK$5.09b falling due within a year, and liabilities of HK$14.6b due beyond that. Offsetting these obligations, it had cash of HK$9.93b as well as receivables valued at HK$51.0m due within 12 months. So it has liabilities totalling HK$9.74b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of HK$9.70b, we think shareholders really should watch Lifestyle International Holdings's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Strangely Lifestyle International Holdings has a sky high EBITDA ratio of 7.2, implying high debt, but a strong interest coverage of 10.5. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly, Lifestyle International Holdings's EBIT fell a jaw-dropping 54% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lifestyle 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Lifestyle International Holdings generated free cash flow amounting to a very robust 88% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

On the face of it, Lifestyle International Holdings's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow 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 Lifestyle International Holdings stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less 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. Take risks, for example - Lifestyle International Holdings has 3 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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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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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