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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Hingtex Holdings Limited (HKG:1968) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Hingtex Holdings's Net Debt?
The chart below, which you can click on for greater detail, shows that Hingtex Holdings had HK$97.4m in debt in June 2019; about the same as the year before. But on the other hand it also has HK$166.7m in cash, leading to a HK$69.3m net cash position.
How Healthy Is Hingtex Holdings's Balance Sheet?
We can see from the most recent balance sheet that Hingtex Holdings had liabilities of HK$193.2m falling due within a year, and liabilities of HK$10.0m due beyond that. Offsetting this, it had HK$166.7m in cash and HK$78.8m in receivables that were due within 12 months. So it can boast HK$42.2m more liquid assets than total liabilities.
This surplus suggests that Hingtex Holdings is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, Hingtex Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Hingtex Holdings if management cannot prevent a repeat of the 65% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Hingtex Holdings's earnings that will influence how the balance sheet holds up in the future. 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. Hingtex Holdings 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. Considering the last three years, Hingtex Holdings actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While we empathize with investors who find debt concerning, you should keep in mind that Hingtex Holdings has net cash of HK$69.3m, as well as more liquid assets than liabilities. So we are not troubled with Hingtex Holdings's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 5 warning signs we've spotted with Hingtex Holdings (including 1 which is can't be ignored) .
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.
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.
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