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.’ 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. Importantly, CK Asset Holdings Limited (HKG:1113) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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.
What Is CK Asset Holdings’s Net Debt?
The image below, which you can click on for greater detail, shows that at December 2021 CK Asset Holdings had debt of HK$96.5b, up from HK$77.9b in one year. However, it also had HK$62.6b in cash, and so its net debt is HK$33.9b.
A Look At CK Asset Holdings’ Liabilities
Zooming in on the latest balance sheet data, we can see that CK Asset Holdings had liabilities of HK$78.5b due within 12 months and liabilities of HK$91.9b due beyond that. Offsetting these obligations, it had cash of HK$62.6b as well as receivables valued at HK$4.99b due within 12 months. So its liabilities total HK$102.9b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since CK Asset Holdings has a huge market capitalization of HK$189.8b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
CK Asset Holdings has a low debt to EBITDA ratio of only 1.2. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there’s no doubt this company can take on debt while staying cool as a cucumber. The good news is that CK Asset Holdings has increased its EBIT by 7.8% over twelve months, which should ease any concerns about debt repayment. 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 CK Asset Holdings’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, CK Asset Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
The good news is that CK Asset Holdings’s demonstrated ability to cover its interest expense with its EBIT 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. When we consider the range of factors above, it looks like CK Asset Holdings is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we’ve spotted 1 warning sign for CK Asset Holdings you should know about.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.