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 Kelfred Holdings Limited (HKG:1134) makes use of debt. But should shareholders be worried about its use of debt?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.
How Much Debt Does Kelfred Holdings Carry?
As you can see below, Kelfred Holdings had HK$30.9m of debt at June 2019, down from HK$41.7m a year prior. However, it also had HK$13.4m in cash, and so its net debt is HK$17.5m.
How Healthy Is Kelfred Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kelfred Holdings had liabilities of HK$112.4m due within 12 months and liabilities of HK$4.59m due beyond that. Offsetting these obligations, it had cash of HK$13.4m as well as receivables valued at HK$94.0m due within 12 months. So its liabilities total HK$9.67m more than the combination of its cash and short-term receivables.
Given Kelfred Holdings has a market capitalization of HK$425.0m, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). 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).
Kelfred Holdings has a low net debt to EBITDA ratio of only 0.32. And its EBIT covers its interest expense a whopping 19.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Kelfred Holdings grew its EBIT by 15% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Kelfred Holdings will need earnings to service that debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Kelfred Holdings's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
The good news is that Kelfred Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! It's also worth noting that Kelfred Holdings is in the Medical Equipment industry, which is often considered to be quite defensive. Zooming out, Kelfred Holdings seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Kelfred Holdings's earnings per share history for free.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.