Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Capinfo Company Limited (HKG:1075) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is Capinfo's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Capinfo had debt of CN¥245.9m, up from none in one year. However, it does have CN¥479.2m in cash offsetting this, leading to net cash of CN¥233.3m.
A Look At Capinfo's Liabilities
Zooming in on the latest balance sheet data, we can see that Capinfo had liabilities of CN¥1.17b due within 12 months and liabilities of CN¥63.8m due beyond that. On the other hand, it had cash of CN¥479.2m and CN¥501.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥254.5m.
While this might seem like a lot, it is not so bad since Capinfo has a market capitalization of CN¥828.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Capinfo boasts net cash, so it's fair to say it does not have a heavy debt load!
But the other side of the story is that Capinfo saw its EBIT decline by 9.2% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Capinfo will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Capinfo 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. Happily for any shareholders, Capinfo actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While Capinfo does have more liabilities than liquid assets, it also has net cash of CN¥233m. And it impressed us with free cash flow of CN¥182m, being 118% of its EBIT. So we are not troubled with Capinfo's debt use. Given Capinfo has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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