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. Importantly, Water Oasis Group Limited (HKG:1161) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Water Oasis Group's Net Debt?
The image below, which you can click on for greater detail, shows that Water Oasis Group had debt of HK$14.8m at the end of March 2019, a reduction from HK$18.2m over a year. But on the other hand it also has HK$419.1m in cash, leading to a HK$404.3m net cash position.
How Strong Is Water Oasis Group's Balance Sheet?
We can see from the most recent balance sheet that Water Oasis Group had liabilities of HK$679.7m falling due within a year, and liabilities of HK$25.1m due beyond that. Offsetting this, it had HK$419.1m in cash and HK$49.8m in receivables that were due within 12 months. So its liabilities total HK$235.9m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Water Oasis Group is worth HK$694.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Water Oasis Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
The good news is that Water Oasis Group has increased its EBIT by 4.6% 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 it is Water Oasis Group'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. While Water Oasis Group 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. Looking at the most recent three years, Water Oasis Group recorded free cash flow of 37% of its EBIT, which is weaker 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$404m. On top of that, it increased its EBIT by 4.6% in the last twelve months. So we are not troubled with Water Oasis Group's debt use. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Water Oasis Group insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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