The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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 Luk Hing Entertainment Group Holdings Limited (HKG:8052) makes use of debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Luk Hing Entertainment Group Holdings’s Debt?
As you can see below, at the end of June 2019, Luk Hing Entertainment Group Holdings had HK$14.8m of debt, up from HK$4.1 a year ago. Click the image for more detail. But on the other hand it also has HK$29.6m in cash, leading to a HK$14.8m net cash position.
How Strong Is Luk Hing Entertainment Group Holdings’s Balance Sheet?
The latest balance sheet data shows that Luk Hing Entertainment Group Holdings had liabilities of HK$56.4m due within a year, and liabilities of HK$54.4m falling due after that. On the other hand, it had cash of HK$29.6m and HK$22.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$59.0m.
This deficit is considerable relative to its market capitalization of HK$75.6m, so it does suggest shareholders should keep an eye on Luk Hing Entertainment Group Holdings’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Luk Hing Entertainment Group Holdings boasts net cash, so it’s fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Luk Hing Entertainment Group Holdings will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Luk Hing Entertainment Group Holdings reported revenue of HK$223m, which is a gain of 18%, although it did not report any earnings before interest and tax. We usually like to see faster growth from unprofitable companies, but each to their own.
So How Risky Is Luk Hing Entertainment Group Holdings?
We have no doubt that loss making companies are, in general, riskier than profitable ones. And the fact is that over the last twelve months Luk Hing Entertainment Group Holdings lost money at the earnings before interest and tax (EBIT) line. And over the same period it saw negative free cash outflow of HK$1.2m and booked a HK$9.8m accounting loss. But the saving grace is the HK$14.8m on the balance sheet. That means it could keep spending at its current rate for more than two years. Summing up, we’re a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Like risks, for instance. Every company has them, and we’ve spotted 3 warning signs for Luk Hing Entertainment Group Holdings (of which 2 are significant!) 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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