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. As with many other companies Chevalier International Holdings Limited (HKG:25) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is Chevalier International Holdings's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Chevalier International Holdings had debt of HK$3.86b, up from HK$3.44b in one year. However, because it has a cash reserve of HK$2.25b, its net debt is less, at about HK$1.61b.
How Strong Is Chevalier International Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Chevalier International Holdings had liabilities of HK$4.25b due within 12 months and liabilities of HK$3.20b due beyond that. Offsetting this, it had HK$2.25b in cash and HK$1.44b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$3.76b.
When you consider that this deficiency exceeds the company's HK$3.39b 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Chevalier International Holdings has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 5.9 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw Chevalier International Holdings grow its EBIT by 7.3% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chevalier International 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.
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. During the last three years, Chevalier International Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
We'd go so far as to say Chevalier International Holdings's conversion of EBIT to free cash flow was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Chevalier International Holdings to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Chevalier International Holdings's dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.