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. We note that Perennial Energy Holdings Limited (HKG:2798) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Perennial Energy Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Perennial Energy Holdings had CN¥79.4m of debt in June 2019, down from CN¥486.0m, one year before. But it also has CN¥212.4m in cash to offset that, meaning it has CN¥133.1m net cash.
A Look At Perennial Energy Holdings's Liabilities
According to the last reported balance sheet, Perennial Energy Holdings had liabilities of CN¥286.8m due within 12 months, and liabilities of CN¥7.44m due beyond 12 months. Offsetting this, it had CN¥212.4m in cash and CN¥196.0m in receivables that were due within 12 months. So it can boast CN¥114.1m more liquid assets than total liabilities.
This surplus suggests that Perennial Energy Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Perennial Energy Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
And we also note warmly that Perennial Energy Holdings grew its EBIT by 10% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But it is Perennial Energy 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Perennial Energy 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, Perennial Energy Holdings's free cash flow amounted to 35% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While we empathize with investors who find debt concerning, you should keep in mind that Perennial Energy Holdings has net cash of CN¥133.1m, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 10% in the last twelve months. So we don't have any problem with Perennial Energy Holdings's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Perennial Energy Holdings you should be aware of, and 2 of them are a bit unpleasant.
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 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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