Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We note that High Fashion International Limited (HKG:608) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is High Fashion International's Debt?
The chart below, which you can click on for greater detail, shows that High Fashion International had HK$1.38b in debt in December 2018; about the same as the year before. However, because it has a cash reserve of HK$983.1m, its net debt is less, at about HK$400.3m.
A Look At High Fashion International's Liabilities
Zooming in on the latest balance sheet data, we can see that High Fashion International had liabilities of HK$1.64b due within 12 months and liabilities of HK$952.1m due beyond that. Offsetting these obligations, it had cash of HK$983.1m as well as receivables valued at HK$700.3m due within 12 months. So it has liabilities totalling HK$906.1m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$519.5m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, High Fashion International would probably need a major re-capitalization if its creditors were to demand repayment.
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.
High Fashion International shareholders face the double whammy of a high net debt to EBITDA ratio (5.8), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. The debt burden here is substantial. Looking on the bright side, High Fashion International boosted its EBIT by a silky 36% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is High Fashion International'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, High Fashion International barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.
On the face of it, High Fashion International's interest cover 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. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Overall, it seems to us that High Fashion International's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Given the risks around High Fashion International's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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