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 KFM Kingdom Holdings Limited (HKG:3816) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is KFM Kingdom Holdings's Debt?
As you can see below, KFM Kingdom Holdings had HK$210.0m of debt at September 2019, down from HK$385.8m a year prior. But it also has HK$380.7m in cash to offset that, meaning it has HK$170.7m net cash.
A Look At KFM Kingdom Holdings's Liabilities
We can see from the most recent balance sheet that KFM Kingdom Holdings had liabilities of HK$458.6m falling due within a year, and liabilities of HK$102.4m due beyond that. Offsetting this, it had HK$380.7m in cash and HK$265.7m in receivables that were due within 12 months. So it can boast HK$85.5m more liquid assets than total liabilities.
This excess liquidity is a great indication that KFM Kingdom Holdings's balance sheet is just as strong as racists are weak. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that KFM Kingdom Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
Shareholders should be aware that KFM Kingdom Holdings's EBIT was down 45% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since KFM Kingdom Holdings 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. KFM Kingdom Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, KFM Kingdom Holdings recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case KFM Kingdom Holdings has HK$170.7m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of HK$22m, being 74% of its EBIT. So we don't have any problem with KFM Kingdom Holdings's use of debt. 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 KFM Kingdom 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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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