David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Water Oasis Group Limited (HKG:1161) does use debt in its business. But should shareholders be worried about its use of debt?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Water Oasis Group's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Water Oasis Group had HK$13.5m of debt in September 2019, down from HK$16.6m, one year before. However, it does have HK$385.6m in cash offsetting this, leading to net cash of HK$372.1m.
How Healthy Is Water Oasis Group's Balance Sheet?
The latest balance sheet data shows that Water Oasis Group had liabilities of HK$664.7m due within a year, and liabilities of HK$23.8m falling due after that. Offsetting these obligations, it had cash of HK$385.6m as well as receivables valued at HK$29.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$273.0m.
This deficit isn't so bad because Water Oasis Group is worth HK$544.4m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Water Oasis Group boasts net cash, so it's fair to say it does not have a heavy debt load!
The good news is that Water Oasis Group has increased its EBIT by 5.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Water Oasis Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Water Oasis 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. In the last three years, Water Oasis Group'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 Water Oasis Group does have more liabilities than liquid assets, it also has net cash of HK$372.1m. On top of that, it increased its EBIT by 5.3% in the last twelve months. So we don't have any problem with Water Oasis Group'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. For example, we've discovered 3 warning signs for Water Oasis Group that you should be aware of before investing here.
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.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.