Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Lonking Holdings Limited (HKG:3339) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Lonking Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that Lonking Holdings had debt of CN¥1.29b at the end of June 2019, a reduction from CN¥1.52b over a year. But it also has CN¥4.93b in cash to offset that, meaning it has CN¥3.64b net cash.
A Look At Lonking Holdings's Liabilities
The latest balance sheet data shows that Lonking Holdings had liabilities of CN¥4.93b due within a year, and liabilities of CN¥1.34b falling due after that. Offsetting this, it had CN¥4.93b in cash and CN¥2.98b in receivables that were due within 12 months. So it can boast CN¥1.64b more liquid assets than total liabilities.
This excess liquidity suggests that Lonking Holdings is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Lonking Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Lonking Holdings's EBIT dived 17%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Lonking Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Lonking Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Lonking Holdings produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. 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 Lonking Holdings has CN¥3.6b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥462m, being 79% of its EBIT. So is Lonking Holdings's debt a risk? It doesn't seem so to us. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Lonking Holdings insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.