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. 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, Analogue Holdings Limited (HKG:1977) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Analogue Holdings Carry?
As you can see below, at the end of June 2019, Analogue Holdings had HK$112.9m of debt, up from HK$92.2 a year ago. Click the image for more detail. However, its balance sheet shows it holds HK$495.1m in cash, so it actually has HK$382.2m net cash.
How Healthy Is Analogue Holdings's Balance Sheet?
According to the last reported balance sheet, Analogue Holdings had liabilities of HK$1.73b due within 12 months, and liabilities of HK$43.7m due beyond 12 months. On the other hand, it had cash of HK$495.1m and HK$1.86b worth of receivables due within a year. So it actually has HK$588.0m more liquid assets than total liabilities.
This luscious liquidity implies that Analogue Holdings's balance sheet is sturdy like a giant sequoia tree. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that Analogue Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Analogue Holdings's saving grace is its low debt levels, because its EBIT has tanked 41% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Analogue Holdings's earnings that will influence how the balance sheet holds up in the future. 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. While Analogue Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Analogue Holdings recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Analogue Holdings has net cash of HK$382.2m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$20m, being 70% of its EBIT. So is Analogue Holdings's debt a risk? It doesn't seem so to us. Given Analogue Holdings 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.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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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