Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies The United Laboratories International Holdings Limited (HKG:3933) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 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, 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 United Laboratories International Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that United Laboratories International Holdings had CN¥4.14b of debt in December 2018, down from CN¥4.86b, one year before. However, it also had CN¥1.58b in cash, and so its net debt is CN¥2.56b.
SEHK:3933 Historical Debt, August 19th 2019
How Healthy Is United Laboratories International Holdings's Balance Sheet?
We can see from the most recent balance sheet that United Laboratories International Holdings had liabilities of CN¥6.52b falling due within a year, and liabilities of CN¥1.97b due beyond that. On the other hand, it had cash of CN¥1.58b and CN¥3.07b worth of receivables due within a year. So it has liabilities totalling CN¥3.84b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of CN¥5.80b, so it does suggest shareholders should keep an eye on United Laboratories International Holdings's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
United Laboratories International Holdings has net debt worth 1.6 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.0 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that United Laboratories International Holdings's EBIT shot up like bamboo after rain, gaining 56% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine United Laboratories International 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, United Laboratories International Holdings generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Our View
The good news is that United Laboratories International Holdings's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that United Laboratories International Holdings can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that United Laboratories International Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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