The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. We can see that Creative Enterprise Holdings Limited (HKG:3992) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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 think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Creative Enterprise Holdings Carry?
The image below, which you can click on for greater detail, shows that Creative Enterprise Holdings had debt of HK$28.1m at the end of March 2019, a reduction from HK$43.4m over a year. But on the other hand it also has HK$97.7m in cash, leading to a HK$69.5m net cash position.
How Healthy Is Creative Enterprise Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Creative Enterprise Holdings had liabilities of HK$86.4m due within 12 months and liabilities of HK$13.4m due beyond that. On the other hand, it had cash of HK$97.7m and HK$172.1m worth of receivables due within a year. So it can boast HK$170.0m more liquid assets than total liabilities.
This excess liquidity is a great indication that Creative Enterprise Holdings's balance sheet is just as strong as racists are weak. On this view, it seems its balance sheet is as strong as a black-belt karate master. Succinctly put, Creative Enterprise Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Creative Enterprise Holdings saw its EBIT drop by 3.8% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Creative Enterprise Holdings 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. Creative Enterprise Holdings 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. Looking at the most recent three years, Creative Enterprise Holdings recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
While it is always sensible to investigate a company's debt, in this case Creative Enterprise Holdings has HK$69.5m in net cash and a decent-looking balance sheet. So we don't have any problem with Creative Enterprise Holdings's use of debt. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Creative Enterprise Holdings's earnings per share history for free.
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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