Here’s why Kaisa Capital Investment Holdings (HKG:936) has significant leverage

Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that Kaisa Capital Investment Holdings Limited (HKG:936) has a debt on its balance sheet. But the real question is whether this debt makes the business risky.

When is debt dangerous?

Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

Our analysis indicates that 936 is potentially undervalued!

How much debt does Kaisa Capital Investment Holdings have?

The image below, which you can click on for more details, shows that Kaisa Capital Investment Holdings had HK$145.8 million in debt at the end of June 2022, a reduction from HK$199.4 million over a year. However, since he has a cash reserve of HK$25.6 million, his net debt is lower at around HK$120.3 million.

SEHK: 936 Historical Debt to Equity October 13, 2022

How healthy is Kaisa Capital Investment Holdings’ balance sheet?

According to the latest published balance sheet, Kaisa Capital Investment Holdings had liabilities of HK$298.0 million due within 12 months and liabilities of HK$85.1 million due beyond 12 months. As compensation for these obligations, it had cash of HK$25.6 million and receivables valued at HK$41.3 million due within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables of HK$316.3 million.

This is a mountain of leverage compared to its market capitalization of HK$360.4 million. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.

While Kaisa Capital Investment Holdings has a fairly reasonable net debt to EBITDA ratio of 2.3, its interest coverage looks low at 1.7. A big part of it is that it has so much depreciation and amortization. These fees may be non-monetary, so they could be excluded when it comes to repaying the debt. But accounting fees are there for a reason: some assets seem to lose value. Either way, it’s safe to say that the company has significant debt. We also note that Kaisa Capital Investment Holdings improved its EBIT from last year’s loss to a positive result of HK$15 million. There is no doubt that we learn the most about debt from the balance sheet. But it is the earnings of Kaisa Capital Investment Holdings that will influence the balance sheet going forward. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.

Finally, while the taxman may love accounting profits, lenders only accept cash. It is therefore important to check how much of its earnings before interest and taxes (EBIT) converts into actual free cash flow. Over the past year, Kaisa Capital Investment Holdings has actually produced more free cash flow than EBIT. This kind of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our point of view

Neither the ability of Kaisa Capital Investment Holdings to cover its interest charges with its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is that it seems to be able to easily convert EBIT to free cash flow. Looking at all the angles mentioned above, it seems to us that Kaisa Capital Investment Holdings is a somewhat risky investment due to its debt. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. To do this, you need to find out about the 3 warning signs we spotted with Kaisa Capital Investment Holdings (1 of which makes us a little uneasy).

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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