Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. As with many other companies Kato (Hong Kong) Holdings Limited (HKG:2189) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Kato (Hong Kong) Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Kato (Hong Kong) Holdings had HK$23.4m of debt in March 2019, down from HK$26.7m, one year before. However, its balance sheet shows it holds HK$48.7m in cash, so it actually has HK$25.3m net cash.
A Look At Kato (Hong Kong) Holdings's Liabilities
The latest balance sheet data shows that Kato (Hong Kong) Holdings had liabilities of HK$43.8m due within a year, and liabilities of HK$2.23m falling due after that. Offsetting this, it had HK$48.7m in cash and HK$2.68m in receivables that were due within 12 months. So it can boast HK$5.37m more liquid assets than total liabilities.
Having regard to Kato (Hong Kong) Holdings's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the HK$560.0m company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Kato (Hong Kong) Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
Another good sign is that Kato (Hong Kong) Holdings has been able to increase its EBIT by 25% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Kato (Hong Kong) Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Kato (Hong Kong) Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Kato (Hong Kong) Holdings recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Kato (Hong Kong) Holdings has net cash of HK$25.3m, as well as more liquid assets than liabilities. The cherry on top was that in converted 77% of that EBIT to free cash flow, bringing in HK$48m. So is Kato (Hong Kong) Holdings's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in Kato (Hong Kong) Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at email@example.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.