David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Yau Lee Holdings Limited (HKG:406) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Yau Lee Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Yau Lee Holdings had HK$2.34b of debt, an increase on HK$2.25b, over one year. However, it also had HK$836.8m in cash, and so its net debt is HK$1.50b.
A Look At Yau Lee Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Yau Lee Holdings had liabilities of HK$2.51b due within 12 months and liabilities of HK$1.15b due beyond that. Offsetting these obligations, it had cash of HK$836.8m as well as receivables valued at HK$1.86b due within 12 months. So it has liabilities totalling HK$966.7m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the HK$591.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Yau Lee Holdings would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Yau Lee Holdings has a rather high debt to EBITDA ratio of 9.6 which suggests a meaningful debt load. However, its interest coverage of 6.2 is reasonably strong, which is a good sign. We also note that Yau Lee Holdings improved its EBIT from a last year's loss to a positive HK$61m. There's no doubt that we learn most about debt from the balance sheet. But it is Yau Lee 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Yau Lee 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.
On the face of it, Yau Lee Holdings's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Yau Lee Holdings stock 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. Over time, share prices tend to follow earnings per share, so if you're interested in Yau Lee Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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