These 4 Measures Indicate That AKM Industrial (HKG:1639) Is Using Debt Reasonably Well

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.' 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 AKM Industrial Company Limited (HKG:1639) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

See our latest analysis for AKM Industrial

What Is AKM Industrial's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 AKM Industrial had debt of HK$220.6m, up from none in one year. On the flip side, it has HK$35.3m in cash leading to net debt of about HK$185.3m.

How Strong Is AKM Industrial's Balance Sheet?

According to the last reported balance sheet, AKM Industrial had liabilities of HK$641.2m due within 12 months, and liabilities of HK$106.0m due beyond 12 months. Offsetting these obligations, it had cash of HK$35.3m as well as receivables valued at HK$602.5m due within 12 months. So its liabilities total HK$109.3m more than the combination of its cash and short-term receivables.

Of course, AKM Industrial has a market capitalization of HK$1.40b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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 0.90. And its EBIT covers its interest expense a whopping 26.9 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that AKM Industrial grew its EBIT by 578% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since AKM Industrial will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Happily, AKM Industrial's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. Looking at all the aforementioned factors together, it strikes us that AKM Industrial can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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.

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. 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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