Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Yip's Chemical Holdings Limited (HKG:408) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Yip's Chemical Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Yip's Chemical Holdings had HK$2.64b of debt, an increase on HK$2.47b, over one year. However, it does have HK$1.34b in cash offsetting this, leading to net debt of about HK$1.30b.
How Healthy Is Yip's Chemical Holdings's Balance Sheet?
We can see from the most recent balance sheet that Yip's Chemical Holdings had liabilities of HK$3.56b falling due within a year, and liabilities of HK$1.33b due beyond that. Offsetting this, it had HK$1.34b in cash and HK$3.57b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Yip's Chemical Holdings's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the HK$1.29b company is short on cash, but still worth keeping an eye on the balance sheet.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Yip's Chemical Holdings has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.6 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. The bad news is that Yip's Chemical Holdings saw its EBIT decline by 12% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But it is Yip's Chemical Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Yip's Chemical Holdings recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Yip's Chemical Holdings's EBIT growth rate was a real negative on this analysis, although the other factors we considered were considerably better In particular, we thought its level of total liabilities was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Yip's Chemical Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We'd be motivated to research the stock further if we found out that Yip's Chemical Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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