Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 China Leon Inspection Holding Limited (HKG:1586) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Leon Inspection Holding's Net Debt?
As you can see below, at the end of June 2019, China Leon Inspection Holding had CN¥83.0m of debt, up from CN¥17.8m a year ago. Click the image for more detail. But on the other hand it also has CN¥87.7m in cash, leading to a CN¥4.69m net cash position.
How Strong Is China Leon Inspection Holding's Balance Sheet?
The latest balance sheet data shows that China Leon Inspection Holding had liabilities of CN¥152.1m due within a year, and liabilities of CN¥30.0m falling due after that. On the other hand, it had cash of CN¥87.7m and CN¥82.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥12.2m.
Since publicly traded China Leon Inspection Holding shares are worth a total of CN¥457.2m, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, China Leon Inspection Holding also has more cash than debt, so we're pretty confident it can manage its debt safely.
Sadly, China Leon Inspection Holding's EBIT actually dropped 3.2% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since China Leon Inspection Holding will need earnings to service that debt. 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. China Leon Inspection Holding 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, China Leon Inspection Holding recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
While it is always sensible to look at a company's total liabilities, it is very reassuring that China Leon Inspection Holding has CN¥4.7m in net cash. So although we see some areas for improvement, we're not too worried about China Leon Inspection Holding's balance sheet. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
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