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. We note that Asia Commercial Holdings Limited (HKG:104) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
How Much Debt Does Asia Commercial Holdings Carry?
As you can see below, at the end of March 2019, Asia Commercial Holdings had HK$130.7m of debt, up from HK$14.4m a year ago. Click the image for more detail. However, because it has a cash reserve of HK$111.9m, its net debt is less, at about HK$18.8m.
How Strong Is Asia Commercial Holdings's Balance Sheet?
We can see from the most recent balance sheet that Asia Commercial Holdings had liabilities of HK$259.4m falling due within a year, and liabilities of HK$33.7m due beyond that. On the other hand, it had cash of HK$111.9m and HK$47.6m worth of receivables due within a year. So it has liabilities totalling HK$133.6m more than its cash and near-term receivables, combined.
Asia Commercial Holdings has a market capitalization of HK$332.5m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Asia Commercial Holdings's net debt is only 0.21 times its EBITDA. And its EBIT easily covers its interest expense, being 189 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, Asia Commercial Holdings grew its EBIT by 128% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But it is Asia Commercial Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
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 last three years, Asia Commercial Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
The good news is that Asia Commercial Holdings's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Overall, we don't think Asia Commercial Holdings is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. We'd be very excited to see if Asia Commercial Holdings insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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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