We Think Keen Ocean International Holding (HKG:8070) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Keen Ocean International Holding Limited (HKG:8070) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Keen Ocean International Holding

How Much Debt Does Keen Ocean International Holding Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Keen Ocean International Holding had HK$54.6m of debt, an increase on HK$47.0m, over one year. However, it does have HK$22.5m in cash offsetting this, leading to net debt of about HK$32.1m.

A Look At Keen Ocean International Holding's Liabilities

According to the balance sheet data, Keen Ocean International Holding had liabilities of HK$156.4m due within 12 months, but no longer term liabilities. Offsetting this, it had HK$22.5m in cash and HK$76.7m in receivables that were due within 12 months. So its liabilities total HK$57.2m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's HK$49.6m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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).

With net debt sitting at just 1.1 times EBITDA, Keen Ocean International Holding is arguably pretty conservatively geared. And it boasts interest cover of 8.3 times, which is more than adequate. On top of that, Keen Ocean International Holding grew its EBIT by 91% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Keen Ocean International Holding'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Keen Ocean International Holding created free cash flow amounting to 4.8% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Keen Ocean International Holding's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Keen Ocean International Holding is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that Keen Ocean International Holding is showing 2 warning signs in our investment analysis , and 1 of those is concerning...

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.

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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.