Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Digital Domain Holdings Limited (HKG:547) does carry debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Digital Domain Holdings Carry?
As you can see below, Digital Domain Holdings had HK$274.4m of debt at December 2019, down from HK$554.0m a year prior. However, it does have HK$330.7m in cash offsetting this, leading to net cash of HK$56.4m.
A Look At Digital Domain Holdings's Liabilities
We can see from the most recent balance sheet that Digital Domain Holdings had liabilities of HK$299.6m falling due within a year, and liabilities of HK$398.3m due beyond that. Offsetting this, it had HK$330.7m in cash and HK$125.9m in receivables that were due within 12 months. So it has liabilities totalling HK$241.3m more than its cash and near-term receivables, combined.
Since publicly traded Digital Domain Holdings shares are worth a total of HK$1.50b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Digital Domain Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Digital Domain Holdings'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 Digital Domain Holdings wasn't profitable at an EBIT level, but managed to grow its revenue by 4.1%, to HK$625m. That rate of growth is a bit slow for our taste, but it takes all types to make a world.
So How Risky Is Digital Domain Holdings?
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 Digital Domain Holdings had negative earnings before interest and tax (EBIT), over the last year. And over the same period it saw negative free cash outflow of HK$320m and booked a HK$401m accounting loss. But at least it has HK$56.4m on the balance sheet to spend on growth, near-term. Overall, we'd say the stock is a bit risky, and we're usually very cautious until we see positive free cash flow. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Digital Domain Holdings has 5 warning signs (and 2 which are potentially serious) we think you should know about.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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