Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 note that Huazhang Technology Holding Limited (HKG:1673) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Huazhang Technology Holding's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Huazhang Technology Holding had CN¥140.3m of debt, an increase on CN¥97.6m, over one year. However, it does have CN¥53.0m in cash offsetting this, leading to net debt of about CN¥87.4m.
How Strong Is Huazhang Technology Holding's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Huazhang Technology Holding had liabilities of CN¥598.6m due within 12 months and liabilities of CN¥32.4m due beyond that. On the other hand, it had cash of CN¥53.0m and CN¥689.0m worth of receivables due within a year. So it can boast CN¥111.0m more liquid assets than total liabilities.
This short term liquidity is a sign that Huazhang Technology Holding could probably pay off its debt with ease, as its balance sheet is far from stretched.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We'd say that Huazhang Technology Holding's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. Importantly, Huazhang Technology Holding's EBIT fell a jaw-dropping 49% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But it is Huazhang Technology Holding'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Huazhang Technology Holding burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
Neither Huazhang Technology Holding's ability to grow its EBIT nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Huazhang Technology Holding's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Huazhang Technology Holding insiders have sold any shares recently. You click here to find out if insiders have sold recently.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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