David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Keong Hong Holdings Limited (SGX:5TT) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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.
How Much Debt Does Keong Hong Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Keong Hong Holdings had debt of S$129.5m, up from S$122.4m in one year. However, it does have S$56.6m in cash offsetting this, leading to net debt of about S$72.9m.
A Look At Keong Hong Holdings's Liabilities
The latest balance sheet data shows that Keong Hong Holdings had liabilities of S$169.4m due within a year, and liabilities of S$93.7m falling due after that. Offsetting these obligations, it had cash of S$56.6m as well as receivables valued at S$118.2m due within 12 months. So its liabilities total S$88.3m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of S$102.2m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Keong Hong Holdings's net debt is 4.4 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 1k is very high, suggesting that the interest expense may well rise in the future, even if there hasn't yet been a major cost attached to that debt. We saw Keong Hong Holdings grow its EBIT by 3.3% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Keong Hong 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Keong Hong Holdings generated free cash flow amounting to a very robust 81% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Both Keong Hong Holdings's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Keong Hong Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that Keong Hong Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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