Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 can see that Guangdong Investment Limited (HKG:270) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 Guangdong Investment Carry?
The image below, which you can click on for greater detail, shows that at December 2018 Guangdong Investment had debt of HK$9.88b, up from HK$6.59b in one year. However, its balance sheet shows it holds HK$16.6b in cash, so it actually has HK$6.76b net cash.
A Look At Guangdong Investment's Liabilities
The latest balance sheet data shows that Guangdong Investment had liabilities of HK$9.22b due within a year, and liabilities of HK$14.5b falling due after that. Offsetting this, it had HK$16.6b in cash and HK$1.22b in receivables that were due within 12 months. So its liabilities total HK$5.85b more than the combination of its cash and short-term receivables.
Since publicly traded Guangdong Investment shares are worth a very impressive total of HK$109.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Guangdong Investment boasts net cash, so it's fair to say it does not have a heavy debt load!
Fortunately, Guangdong Investment grew its EBIT by 2.2% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Guangdong Investment's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Guangdong Investment 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, Guangdong Investment generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
We could understand if investors are concerned about Guangdong Investment's liabilities, but we can be reassured by the fact it has has net cash of HK$6.8b. And it impressed us with free cash flow of HK$5.6b, being 95% of its EBIT. So we don't think Guangdong Investment's use of debt is risky. Another factor that would give us confidence in Guangdong Investment would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly 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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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. Thank you for reading.