Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. As with many other companies Hung Fook Tong Group Holdings Limited (HKG:1446) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Hung Fook Tong Group Holdings Carry?
The chart below, which you can click on for greater detail, shows that Hung Fook Tong Group Holdings had HK$86.4m in debt in June 2019; about the same as the year before. On the flip side, it has HK$82.6m in cash leading to net debt of about HK$3.77m.
A Look At Hung Fook Tong Group Holdings's Liabilities
The latest balance sheet data shows that Hung Fook Tong Group Holdings had liabilities of HK$358.3m due within a year, and liabilities of HK$94.8m falling due after that. On the other hand, it had cash of HK$82.6m and HK$45.9m worth of receivables due within a year. So its liabilities total HK$324.6m more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of HK$278.8m, we think shareholders really should watch Hung Fook Tong Group Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Hung Fook Tong Group Holdings has a very little net debt but plenty of other liabilities weighing it down.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Hung Fook Tong Group Holdings's debt of just 0.089 times EBITDA is really very modest. And this impression is enhanced by its strong EBIT which covers interest costs 7.3 times. While Hung Fook Tong Group Holdings doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Hung Fook Tong Group 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last two years, Hung Fook Tong 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.
Mulling over Hung Fook Tong Group Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Hung Fook Tong Group Holdings's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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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.