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 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, SH Group (Holdings) Limited (HKG:1637) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is SH Group (Holdings)'s Net Debt?
As you can see below, SH Group (Holdings) had HK$9.16m of debt at March 2019, down from HK$12.1m a year prior. However, it does have HK$99.4m in cash offsetting this, leading to net cash of HK$90.2m.
How Strong Is SH Group (Holdings)'s Balance Sheet?
We can see from the most recent balance sheet that SH Group (Holdings) had liabilities of HK$106.7m falling due within a year, and liabilities of HK$374.0k due beyond that. On the other hand, it had cash of HK$99.4m and HK$205.1m worth of receivables due within a year. So it can boast HK$197.4m more liquid assets than total liabilities.
This surplus liquidity suggests that SH Group (Holdings)'s balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, SH Group (Holdings) boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that SH Group (Holdings)'s load is not too heavy, because its EBIT was down 41% over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since SH Group (Holdings) will need earnings to service that debt. 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 SH Group (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 last three years, SH Group (Holdings) recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
While we empathize with investors who find debt concerning, the bottom line is that SH Group (Holdings) has net cash of HK$90.2m and plenty of liquid assets. So we don't have any problem with SH Group (Holdings)'s use of debt. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check SH Group (Holdings)'s dividend history, without delay!
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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