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 can see that Lion Rock Group Limited (HKG:1127) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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. 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.
What Is Lion Rock Group's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Lion Rock Group had HK$271.3m of debt, an increase on HK$127, over one year. However, it does have HK$473.7m in cash offsetting this, leading to net cash of HK$202.4m.
How Healthy Is Lion Rock Group's Balance Sheet?
We can see from the most recent balance sheet that Lion Rock Group had liabilities of HK$576.8m falling due within a year, and liabilities of HK$84.8m due beyond that. Offsetting these obligations, it had cash of HK$473.7m as well as receivables valued at HK$547.4m due within 12 months. So it actually has HK$359.6m more liquid assets than total liabilities.
This excess liquidity is a great indication that Lion Rock Group's balance sheet is just as strong as racists are weak. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, Lion Rock Group boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, Lion Rock Group saw its EBIT drop by 9.8% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is Lion Rock Group'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. Lion Rock Group 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. During the last three years, Lion Rock Group produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. 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 Lion Rock Group has net cash of HK$202.4m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$71m, being 66% of its EBIT. So we don't think Lion Rock Group's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Lion Rock Group you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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