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. We can see that Herald Holdings Limited (HKG:114) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Herald Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that Herald Holdings had debt of HK$40.2m at the end of March 2019, a reduction from HK$107.3m over a year. But on the other hand it also has HK$222.4m in cash, leading to a HK$182.1m net cash position.
How Healthy Is Herald Holdings's Balance Sheet?
We can see from the most recent balance sheet that Herald Holdings had liabilities of HK$214.6m falling due within a year, and liabilities of HK$21.9m due beyond that. Offsetting this, it had HK$222.4m in cash and HK$95.3m in receivables that were due within 12 months. So it actually has HK$81.1m more liquid assets than total liabilities.
This excess liquidity suggests that Herald Holdings is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Succinctly put, Herald Holdings boasts net cash, so it's fair to say it does not have a heavy debt load! 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 Herald 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.
Over 12 months, Herald Holdings saw its revenue drop to HK$952m, which is a fall of 25%. To be frank that doesn't bode well.
So How Risky Is Herald Holdings?
Although Herald Holdings had negative earnings before interest and tax (EBIT) over the last twelve months, it generated positive free cash flow of HK$7.0m. So taking that on face value, and considering the net cash situation, we don't think that the stock is too risky in the near term. We'll feel more comfortable with the stock once EBIT is positive, given the lacklustre revenue growth. When I consider a company to be a bit risky, I think it is responsible to check out whether insiders have been reporting any share sales. Luckily, you can click here ito see our graphic depicting Herald Holdings insider transactions.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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