Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Aoyuan Healthy Life Group Company Limited (HKG:3662) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Aoyuan Healthy Life Group's Debt?
The image below, which you can click on for greater detail, shows that at December 2019 Aoyuan Healthy Life Group had debt of CN¥100.3m, up from CN¥1.78m in one year. But on the other hand it also has CN¥822.9m in cash, leading to a CN¥722.6m net cash position.
How Healthy Is Aoyuan Healthy Life Group's Balance Sheet?
According to the last reported balance sheet, Aoyuan Healthy Life Group had liabilities of CN¥526.1m due within 12 months, and liabilities of CN¥13.9m due beyond 12 months. On the other hand, it had cash of CN¥822.9m and CN¥205.7m worth of receivables due within a year. So it actually has CN¥488.5m more liquid assets than total liabilities.
This short term liquidity is a sign that Aoyuan Healthy Life Group could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that Aoyuan Healthy Life Group has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, Aoyuan Healthy Life Group grew its EBIT by 75% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Aoyuan Healthy Life Group can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Aoyuan Healthy Life Group 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. Over the last three years, Aoyuan Healthy Life Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company's debt, in this case Aoyuan Healthy Life Group has CN¥722.6m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥329m, being 135% of its EBIT. So is Aoyuan Healthy Life Group's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Aoyuan Healthy Life Group has 2 warning signs we think you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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