Luk Fook Holdings (International) (HKG:590) Seems To Use Debt Quite Sensibly

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Luk Fook Holdings (International) Limited (HKG:590) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Luk Fook Holdings (International)

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

As you can see below, at the end of September 2023, Luk Fook Holdings (International) had HK$1.15b of debt, up from HK$523.1m a year ago. Click the image for more detail. But it also has HK$2.25b in cash to offset that, meaning it has HK$1.10b net cash.

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

According to the last reported balance sheet, Luk Fook Holdings (International) had liabilities of HK$3.18b due within 12 months, and liabilities of HK$346.3m due beyond 12 months. Offsetting these obligations, it had cash of HK$2.25b as well as receivables valued at HK$451.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$823.1m.

Since publicly traded Luk Fook Holdings (International) shares are worth a total of HK$11.6b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Luk Fook Holdings (International) boasts net cash, so it's fair to say it does not have a heavy debt load!

Also good is that Luk Fook Holdings (International) grew its EBIT at 17% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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 53% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

We could understand if investors are concerned about Luk Fook Holdings (International)'s liabilities, but we can be reassured by the fact it has has net cash of HK$1.10b. And we liked the look of last year's 17% year-on-year EBIT growth. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Luk Fook Holdings (International) .

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.