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. As with many other companies Tokyo Chuo Auction Holdings Limited (HKG:1939) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Tokyo Chuo Auction Holdings Carry?
The image below, which you can click on for greater detail, shows that Tokyo Chuo Auction Holdings had debt of HK$35.0m at the end of March 2019, a reduction from HK$59.4m over a year. But on the other hand it also has HK$251.4m in cash, leading to a HK$216.3m net cash position.
How Strong Is Tokyo Chuo Auction Holdings's Balance Sheet?
We can see from the most recent balance sheet that Tokyo Chuo Auction Holdings had liabilities of HK$251.7m falling due within a year, and liabilities of HK$12.4m due beyond that. Offsetting this, it had HK$251.4m in cash and HK$212.0m in receivables that were due within 12 months. So it can boast HK$199.3m more liquid assets than total liabilities.
This surplus liquidity suggests that Tokyo Chuo Auction Holdings's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, it seems its balance sheet is as strong as a black-belt karate master. Succinctly put, Tokyo Chuo Auction Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact Tokyo Chuo Auction Holdings's saving grace is its low debt levels, because its EBIT has tanked 72% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Tokyo Chuo Auction Holdings's earnings that will influence how the balance sheet holds up in the future. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Tokyo Chuo Auction 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. During the last three years, Tokyo Chuo Auction Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
While we empathize with investors who find debt concerning, you should keep in mind that Tokyo Chuo Auction Holdings has net cash of HK$216m, as well as more liquid assets than liabilities. So we don't have any problem with Tokyo Chuo Auction Holdings's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Tokyo Chuo Auction 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.
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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. Thank you for reading.