Is Luk Fook Holdings (International) (HKG:590) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Luk Fook Holdings (International) Limited (HKG:590) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Luk Fook Holdings (International)

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

You can click the graphic below for the historical numbers, but it shows that Luk Fook Holdings (International) had HK$523.1m of debt in September 2022, down from HK$2.15b, one year before. However, its balance sheet shows it holds HK$2.42b in cash, so it actually has HK$1.90b net cash.

A Look At Luk Fook Holdings (International)'s Liabilities

Zooming in on the latest balance sheet data, we can see that Luk Fook Holdings (International) had liabilities of HK$2.38b due within 12 months and liabilities of HK$211.7m due beyond that. Offsetting these obligations, it had cash of HK$2.42b as well as receivables valued at HK$431.9m due within 12 months. So it actually has HK$264.9m more liquid assets than total liabilities.

Having regard to Luk Fook Holdings (International)'s size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the HK$14.1b company is struggling for cash, we still think it's worth monitoring its balance sheet. 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.

On the other hand, Luk Fook Holdings (International) saw its EBIT drop by 3.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Luk Fook Holdings (International)'s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept 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. Happily for any shareholders, Luk Fook Holdings (International) actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing Up

While it is always sensible to investigate a company's debt, in this case Luk Fook Holdings (International) has HK$1.90b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of HK$775m, being 116% of its EBIT. So is Luk Fook Holdings (International)'s debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Luk Fook Holdings (International) you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.