Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Sunny Optical Technology (Group) Company Limited (HKG:2382) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Sunny Optical Technology (Group)'s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Sunny Optical Technology (Group) had debt of CN¥5.20b, up from CN¥5.4k in one year. However, its balance sheet shows it holds CN¥6.15b in cash, so it actually has CN¥951.3m net cash.
How Healthy Is Sunny Optical Technology (Group)'s Balance Sheet?
The latest balance sheet data shows that Sunny Optical Technology (Group) had liabilities of CN¥10.2b due within a year, and liabilities of CN¥5.15b falling due after that. Offsetting this, it had CN¥6.15b in cash and CN¥7.45b in receivables that were due within 12 months. So its liabilities total CN¥1.72b more than the combination of its cash and short-term receivables.
Having regard to Sunny Optical Technology (Group)'s size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥137.9b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, Sunny Optical Technology (Group) also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that Sunny Optical Technology (Group) saw its EBIT decline by 8.7% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sunny Optical Technology (Group)'s ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Sunny Optical Technology (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, Sunny Optical Technology (Group)'s free cash flow amounted to 26% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
We could understand if investors are concerned about Sunny Optical Technology (Group)'s liabilities, but we can be reassured by the fact it has has net cash of CN¥951.3m. So we are not troubled with Sunny Optical Technology (Group)'s debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Sunny Optical Technology (Group) that you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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