Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Eternity Technology Holdings Limited (HKG:1725) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Eternity Technology Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Eternity Technology Holdings had debt of CN¥17.3m, up from CN¥12.7 in one year. But on the other hand it also has CN¥150.6m in cash, leading to a CN¥133.3m net cash position.
How Healthy Is Eternity Technology Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Eternity Technology Holdings had liabilities of CN¥207.9m due within 12 months and liabilities of CN¥3.13m due beyond that. Offsetting these obligations, it had cash of CN¥150.6m as well as receivables valued at CN¥131.2m due within 12 months. So it can boast CN¥70.7m more liquid assets than total liabilities.
This surplus suggests that Eternity Technology Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Eternity Technology Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Eternity Technology Holdings if management cannot prevent a repeat of the 28% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Eternity Technology 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 company can only pay off debt with cold hard cash, not accounting profits. While Eternity Technology 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. In the last three years, Eternity Technology Holdings's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Eternity Technology Holdings has net cash of CN¥133.3m, as well as more liquid assets than liabilities. So we don't have any problem with Eternity Technology Holdings's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Eternity Technology Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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