David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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. As with many other companies Ajisen (China) Holdings Limited (HKG:538) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Ajisen (China) Holdings's Net Debt?
As you can see below, Ajisen (China) Holdings had CN¥232.0m of debt at December 2019, down from CN¥267.2m a year prior. But on the other hand it also has CN¥1.71b in cash, leading to a CN¥1.47b net cash position.
How Healthy Is Ajisen (China) Holdings's Balance Sheet?
We can see from the most recent balance sheet that Ajisen (China) Holdings had liabilities of CN¥817.2m falling due within a year, and liabilities of CN¥701.6m due beyond that. On the other hand, it had cash of CN¥1.71b and CN¥110.8m worth of receivables due within a year. So it actually has CN¥297.4m more liquid assets than total liabilities.
This surplus suggests that Ajisen (China) Holdings is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Ajisen (China) Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Ajisen (China) Holdings's load is not too heavy, because its EBIT was down 49% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ajisen (China) Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Ajisen (China) Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Ajisen (China) Holdings recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While it is always sensible to investigate a company's debt, in this case Ajisen (China) Holdings has CN¥1.47b in net cash and a decent-looking balance sheet. So we are not troubled with Ajisen (China) Holdings's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Ajisen (China) Holdings (1 makes us a bit uncomfortable) you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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