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. 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 BHCC Holding Limited (HKG:1552) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does BHCC Holding Carry?
The image below, which you can click on for greater detail, shows that at June 2019 BHCC Holding had debt of S$16.8m, up from S$6.11m in one year. However, its balance sheet shows it holds S$27.9m in cash, so it actually has S$11.1m net cash.
A Look At BHCC Holding's Liabilities
The latest balance sheet data shows that BHCC Holding had liabilities of S$29.9m due within a year, and liabilities of S$15.7m falling due after that. On the other hand, it had cash of S$27.9m and S$22.8m worth of receivables due within a year. So it can boast S$5.17m more liquid assets than total liabilities.
This excess liquidity suggests that BHCC Holding is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, BHCC Holding boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact BHCC Holding's saving grace is its low debt levels, because its EBIT has tanked 53% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since BHCC Holding 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While BHCC Holding has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, BHCC Holding recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While it is always sensible to investigate a company's debt, in this case BHCC Holding has S$11.1m in net cash and a decent-looking balance sheet. So we don't have any problem with BHCC Holding's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of BHCC Holding's earnings per share history for free.
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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