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. 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 Kingworld Medicines Group Limited (HKG:1110) makes use of 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 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Kingworld Medicines Group's Debt?
You can click the graphic below for the historical numbers, but it shows that Kingworld Medicines Group had CN¥270.0m of debt in June 2019, down from CN¥346.0m, one year before. On the flip side, it has CN¥172.4m in cash leading to net debt of about CN¥97.6m.
How Healthy Is Kingworld Medicines Group's Balance Sheet?
According to the last reported balance sheet, Kingworld Medicines Group had liabilities of CN¥514.1m due within 12 months, and liabilities of CN¥33.2m due beyond 12 months. Offsetting this, it had CN¥172.4m in cash and CN¥426.8m in receivables that were due within 12 months. So it can boast CN¥52.0m more liquid assets than total liabilities.
This surplus suggests that Kingworld Medicines Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Kingworld Medicines Group's low debt to EBITDA ratio of 0.96 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.2 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Also positive, Kingworld Medicines Group grew its EBIT by 23% in the last year, and that should make it 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 Kingworld Medicines Group 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.
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 most recent three years, Kingworld Medicines Group recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Kingworld Medicines Group's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. It's also worth noting that Kingworld Medicines Group is in the Healthcare industry, which is often considered to be quite defensive. Zooming out, Kingworld Medicines Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in Kingworld Medicines Group, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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