Luk Fook Holdings (International) (HKG:590) Seems To Use Debt Rather Sparingly

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. We note that Luk Fook Holdings (International) Limited (HKG:590) does have debt on its balance sheet. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Luk Fook Holdings (International)

How Much Debt Does Luk Fook Holdings (International) Carry?

The image below, which you can click on for greater detail, shows that Luk Fook Holdings (International) had debt of HK$1.09b at the end of March 2021, a reduction from HK$1.51b over a year. However, it does have HK$3.55b in cash offsetting this, leading to net cash of HK$2.46b.

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

We can see from the most recent balance sheet that Luk Fook Holdings (International) had liabilities of HK$2.95b falling due within a year, and liabilities of HK$241.0m due beyond that. On the other hand, it had cash of HK$3.55b and HK$605.5m worth of receivables due within a year. So it actually has HK$964.0m more liquid assets than total liabilities.

This short term liquidity is a sign that Luk Fook Holdings (International) could probably pay off its debt with ease, as its balance sheet is far from stretched. 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 3.5% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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'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. During the last three years, Luk Fook Holdings (International) generated free cash flow amounting to a very robust 97% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

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$2.46b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$2.3b, being 97% of its EBIT. So is Luk Fook Holdings (International)'s debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Luk Fook Holdings (International) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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