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. We note that E. Bon Holdings Limited (HKG:599) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is E. Bon Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 E. Bon Holdings had HK$30.6m of debt, an increase on HK$15.4, over one year. But it also has HK$79.8m in cash to offset that, meaning it has HK$49.1m net cash.
How Strong Is E. Bon Holdings's Balance Sheet?
According to the last reported balance sheet, E. Bon Holdings had liabilities of HK$190.5m due within 12 months, and liabilities of HK$86.1m due beyond 12 months. On the other hand, it had cash of HK$79.8m and HK$144.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$52.9m.
This deficit isn't so bad because E. Bon Holdings is worth HK$246.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Despite its noteworthy liabilities, E. Bon Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for E. Bon Holdings if management cannot prevent a repeat of the 44% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But it is E. Bon 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. E. Bon 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. Over the most recent three years, E. Bon Holdings recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although E. Bon Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$49.1m. So we don't have any problem with E. Bon Holdings's use of debt. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with E. Bon Holdings (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.