Forward Fashion (International) Holdings (HKG:2528) Seems To Be Using A Lot Of Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Forward Fashion (International) Holdings Company Limited (HKG:2528) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Forward Fashion (International) Holdings

What Is Forward Fashion (International) Holdings's Net Debt?

As you can see below, Forward Fashion (International) Holdings had HK$284.5m of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have HK$206.0m in cash offsetting this, leading to net debt of about HK$78.5m.

How Healthy Is Forward Fashion (International) Holdings' Balance Sheet?

The latest balance sheet data shows that Forward Fashion (International) Holdings had liabilities of HK$579.3m due within a year, and liabilities of HK$165.6m falling due after that. Offsetting these obligations, it had cash of HK$206.0m as well as receivables valued at HK$52.4m due within 12 months. So it has liabilities totalling HK$486.5m more than its cash and near-term receivables, combined.

This deficit casts a shadow over the HK$160.0m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Forward Fashion (International) Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Even though Forward Fashion (International) Holdings's debt is only 1.7, its interest cover is really very low at 0.27. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. We also note that Forward Fashion (International) Holdings improved its EBIT from a last year's loss to a positive HK$5.3m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Forward Fashion (International) Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Forward Fashion (International) 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.

Our View

On the face of it, Forward Fashion (International) Holdings's conversion of EBIT to free cash flow 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. But at least its net debt to EBITDA is not so bad. Taking into account all the aforementioned factors, it looks like Forward Fashion (International) Holdings has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Be aware that Forward Fashion (International) Holdings is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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. 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.