The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Wong's Kong King International (Holdings) Limited (HKG:532) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Wong's Kong King International (Holdings)'s Debt?
The image below, which you can click on for greater detail, shows that Wong's Kong King International (Holdings) had debt of HK$798.0m at the end of June 2019, a reduction from HK$931.1m over a year. However, because it has a cash reserve of HK$375.1m, its net debt is less, at about HK$422.9m.
SEHK:532 Historical Debt, September 24th 2019
How Healthy Is Wong's Kong King International (Holdings)'s Balance Sheet?
We can see from the most recent balance sheet that Wong's Kong King International (Holdings) had liabilities of HK$1.86b falling due within a year, and liabilities of HK$34.9m due beyond that. On the other hand, it had cash of HK$375.1m and HK$1.55b worth of receivables due within a year. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This surplus suggests that Wong's Kong King International (Holdings) has a conservative balance sheet, and could probably eliminate its debt without much difficulty.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Wong's Kong King International (Holdings) has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Shareholders should be aware that Wong's Kong King International (Holdings)'s EBIT was down 24% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Wong's Kong King International (Holdings)'s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Wong's Kong King International (Holdings) burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Our View
To be frank both Wong's Kong King International (Holdings)'s conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its level of total liabilities is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Wong's Kong King International (Holdings)'s debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Wong's Kong King International (Holdings)'s dividend history, without delay!
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 editorial-team@simplywallst.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.
