AKM Industrial (HKG:1639) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that AKM Industrial Company Limited (HKG:1639) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for AKM Industrial

What Is AKM Industrial's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 AKM Industrial had HK$183.2m of debt, an increase on HK$39.4m, over one year. However, because it has a cash reserve of HK$129.9m, its net debt is less, at about HK$53.4m.

A Look At AKM Industrial's Liabilities

We can see from the most recent balance sheet that AKM Industrial had liabilities of HK$859.0m falling due within a year, and liabilities of HK$105.4m due beyond that. On the other hand, it had cash of HK$129.9m and HK$718.5m worth of receivables due within a year. So it has liabilities totalling HK$116.0m more than its cash and near-term receivables, combined.

Given AKM Industrial has a market capitalization of HK$1.57b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

AKM Industrial has a low net debt to EBITDA ratio of only 0.26. And its EBIT covers its interest expense a whopping 10.4 times over. So we're pretty relaxed about its super-conservative use of debt. While AKM Industrial doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is AKM Industrial's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, AKM Industrial burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Based on what we've seen AKM Industrial is not finding it easy, given its conversion of EBIT to free cash flow, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its net debt to EBITDA. When we consider all the factors mentioned above, we do feel a bit cautious about AKM Industrial's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in AKM Industrial, you may well want to click here to check an interactive graph of its earnings per share history.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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