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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. 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 Canaan Inc. (NASDAQ:CAN) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Canaan's Debt?
As you can see below, Canaan had CN¥99.9m of debt at December 2019, down from CN¥1.05b a year prior. However, its balance sheet shows it holds CN¥533.5m in cash, so it actually has CN¥433.6m net cash.
How Strong Is Canaan's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Canaan had liabilities of CN¥285.2m due within 12 months and liabilities of CN¥13.4m due beyond that. Offsetting these obligations, it had cash of CN¥533.5m as well as receivables valued at CN¥161.1m due within 12 months. So it actually has CN¥396.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Canaan could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Canaan boasts net cash, so it's fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. But it is Canaan'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.
In the last year Canaan had negative earnings before interest and tax, and actually shrunk its revenue by 47%, to CN¥1.4b. To be frank that doesn't bode well.
So How Risky Is Canaan?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that Canaan had negative earnings before interest and tax (EBIT), over the last year. And over the same period it saw negative free cash outflow of CN¥288m and booked a CN¥1.0b accounting loss. But at least it has CN¥433.6m on the balance sheet to spend on growth, near-term. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Canaan is showing 4 warning signs in our investment analysis , and 2 of those are a bit unpleasant...
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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