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Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Kai Yuan Holdings Limited (HKG:1215) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Kai Yuan Holdings
What Is Kai Yuan Holdings's Debt?
The chart below, which you can click on for greater detail, shows that Kai Yuan Holdings had HK$1.53b in debt in June 2019; about the same as the year before. However, because it has a cash reserve of HK$1.24b, its net debt is less, at about HK$287.4m.
How Strong Is Kai Yuan Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Kai Yuan Holdings had liabilities of HK$1.61b due within 12 months and liabilities of HK$255.2m due beyond that. On the other hand, it had cash of HK$1.24b and HK$95.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$530.7m.
When you consider that this deficiency exceeds the company's HK$408.9m 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.
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.
While Kai Yuan Holdings's debt to EBITDA ratio (4.8) suggests that it uses some debt, its interest cover is very weak, at 0.72, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, one redeeming factor is that Kai Yuan Holdings grew its EBIT at 10% over the last 12 months, boosting its ability to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Kai Yuan 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.