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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Lai Sun Garment (International) Limited (HKG:191) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Lai Sun Garment (International) Carry?
As you can see below, at the end of July 2019, Lai Sun Garment (International) had HK$20.4b of debt, up from HK$13.1b a year ago. Click the image for more detail. However, it also had HK$4.12b in cash, and so its net debt is HK$16.3b.
A Look At Lai Sun Garment (International)'s Liabilities
Zooming in on the latest balance sheet data, we can see that Lai Sun Garment (International) had liabilities of HK$9.59b due within 12 months and liabilities of HK$22.0b due beyond that. On the other hand, it had cash of HK$4.12b and HK$302.9m worth of receivables due within a year. So its liabilities total HK$27.1b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the HK$3.25b 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, Lai Sun Garment (International) 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.
Lai Sun Garment (International) has a rather high debt to EBITDA ratio of 13.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.6 times, suggesting it can responsibly service its obligations. Worse, Lai Sun Garment (International)'s EBIT was down 47% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is Lai Sun Garment (International)'s earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Lai Sun Garment (International) reported free cash flow worth 14% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On the face of it, Lai Sun Garment (International)'s EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. And furthermore, its interest cover also fails to instill confidence. We think the chances that Lai Sun Garment (International) has too much debt a very significant. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. Over time, share prices tend to follow earnings per share, so if you're interested in Lai Sun Garment (International), you may well want to click here to check an interactive graph of its earnings per share history.
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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