In This Article:
Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 K2 F&B Holdings Limited (HKG:2108) 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
See our latest analysis for K2 F&B Holdings
What Is K2 F&B Holdings's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 K2 F&B Holdings had debt of S$59.6m, up from S$52.8m in one year. On the flip side, it has S$17.4m in cash leading to net debt of about S$42.3m.
How Healthy Is K2 F&B Holdings's Balance Sheet?
We can see from the most recent balance sheet that K2 F&B Holdings had liabilities of S$8.09m falling due within a year, and liabilities of S$57.7m due beyond that. Offsetting this, it had S$17.4m in cash and S$257.0k in receivables that were due within 12 months. So its liabilities total S$48.2m more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's S$34.9m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).