Here's Why Kong Sun Holdings (HKG:295) Is Weighed Down By Its Debt Load

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.' 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. As with many other companies Kong Sun Holdings Limited (HKG:295) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Kong Sun Holdings

What Is Kong Sun Holdings's Net Debt?

As you can see below, Kong Sun Holdings had CN¥6.56b of debt at December 2020, down from CN¥9.96b a year prior. However, because it has a cash reserve of CN¥190.1m, its net debt is less, at about CN¥6.37b.

How Strong Is Kong Sun Holdings' Balance Sheet?

According to the last reported balance sheet, Kong Sun Holdings had liabilities of CN¥5.69b due within 12 months, and liabilities of CN¥3.91b due beyond 12 months. On the other hand, it had cash of CN¥190.1m and CN¥2.93b worth of receivables due within a year. So its liabilities total CN¥6.48b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the CN¥1.23b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Kong Sun Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.75 times and a disturbingly high net debt to EBITDA ratio of 6.0 hit our confidence in Kong Sun Holdings like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Kong Sun Holdings's EBIT was down 25% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But it is Kong Sun Holdings'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Kong Sun Holdings 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

On the face of it, Kong Sun Holdings's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. It looks to us like Kong Sun Holdings carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Kong Sun Holdings (of which 1 makes us a bit uncomfortable!) 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.

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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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