Here's Why Luk Fook Holdings (International) (HKG:590) Can Manage Its Debt Responsibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Luk Fook Holdings (International) Limited (HKG:590) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Luk Fook Holdings (International)

What Is Luk Fook Holdings (International)'s Debt?

The image below, which you can click on for greater detail, shows that Luk Fook Holdings (International) had debt of HK$634.9m at the end of September 2020, a reduction from HK$1.74b over a year. But on the other hand it also has HK$2.64b in cash, leading to a HK$2.00b net cash position.

How Strong Is Luk Fook Holdings (International)'s Balance Sheet?

The latest balance sheet data shows that Luk Fook Holdings (International) had liabilities of HK$2.36b due within a year, and liabilities of HK$338.3m falling due after that. Offsetting this, it had HK$2.64b in cash and HK$522.4m in receivables that were due within 12 months. So it actually has HK$461.0m more liquid assets than total liabilities.

This surplus suggests that Luk Fook Holdings (International) has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Luk Fook Holdings (International) has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Luk Fook Holdings (International)'s load is not too heavy, because its EBIT was down 53% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Luk Fook Holdings (International) 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Luk Fook Holdings (International) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Luk Fook Holdings (International) recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Luk Fook Holdings (International) has net cash of HK$2.00b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$2.5b, being 71% of its EBIT. So we don't have any problem with Luk Fook Holdings (International)'s use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Luk Fook Holdings (International) has 1 warning sign we think you should be aware of.

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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