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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Kingboard Laminates Holdings Limited (HKG:1888) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Kingboard Laminates Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Kingboard Laminates Holdings had debt of HK$4.67b, up from HK$1.77b in one year. However, it does have HK$3.24b in cash offsetting this, leading to net debt of about HK$1.44b.
How Healthy Is Kingboard Laminates Holdings' Balance Sheet?
According to the last reported balance sheet, Kingboard Laminates Holdings had liabilities of HK$10.2b due within 12 months, and liabilities of HK$744.1m due beyond 12 months. Offsetting this, it had HK$3.24b in cash and HK$10.9b in receivables that were due within 12 months. So it can boast HK$3.23b more liquid assets than total liabilities.
This surplus suggests that Kingboard Laminates Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Kingboard Laminates Holdings has a low net debt to EBITDA ratio of only 0.20. And its EBIT covers its interest expense a whopping 183 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Kingboard Laminates Holdings grew its EBIT by 111% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Kingboard Laminates Holdings'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. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Kingboard Laminates Holdings recorded free cash flow worth 59% 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.
Happily, Kingboard Laminates Holdings's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don't think Kingboard Laminates Holdings is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Kingboard Laminates Holdings you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.
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