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. We note that KWG Group Holdings Limited (HKG:1813) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does KWG Group Holdings Carry?
The image below, which you can click on for greater detail, shows that at December 2018 KWG Group Holdings had debt of CN¥77.8b, up from CN¥59.6b in one year. On the flip side, it has CN¥56.5b in cash leading to net debt of about CN¥21.3b.
How Strong Is KWG Group Holdings's Balance Sheet?
We can see from the most recent balance sheet that KWG Group Holdings had liabilities of CN¥90.7b falling due within a year, and liabilities of CN¥62.1b due beyond that. Offsetting this, it had CN¥56.5b in cash and CN¥1.12b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥95.2b.
This deficit casts a shadow over the CN¥18.7b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, KWG Group Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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.
KWG Group Holdings shareholders face the double whammy of a high net debt to EBITDA ratio (28.0), and fairly weak interest coverage, since EBIT is just 1.0 times the interest expense. The debt burden here is substantial. Worse, KWG Group Holdings's EBIT was down 74% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if KWG Group Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, KWG Group Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both KWG Group Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its interest cover also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that KWG Group Holdings is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. Given the risks around KWG Group Holdings's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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