Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies L.K. Technology Holdings Limited (HKG:558) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for L.K. Technology Holdings

What Is L.K. Technology Holdings's Debt?

The image below, which you can click on for greater detail, shows that L.K. Technology Holdings had debt of HK$1.09b at the end of March 2022, a reduction from HK$1.17b over a year. On the flip side, it has HK$576.8m in cash leading to net debt of about HK$511.8m.

How Strong Is L.K. Technology Holdings' Balance Sheet?

We can see from the most recent balance sheet that L.K. Technology Holdings had liabilities of HK$3.41b falling due within a year, and liabilities of HK$490.9m due beyond that. On the other hand, it had cash of HK$576.8m and HK$2.30b worth of receivables due within a year. So its liabilities total HK$1.02b more than the combination of its cash and short-term receivables.

Of course, L.K. Technology Holdings has a market capitalization of HK$21.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

L.K. Technology Holdings has a low net debt to EBITDA ratio of only 0.57. And its EBIT easily covers its interest expense, being 23.6 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that L.K. Technology Holdings has boosted its EBIT by 60%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine L.K. Technology Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 most recent three years, L.K. Technology Holdings recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, L.K. Technology Holdings's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think L.K. Technology Holdings's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for L.K. Technology Holdings you should be aware of.

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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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.