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.' 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 International Housewares Retail Company Limited (HKG:1373) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is International Housewares Retail's Net Debt?
The image below, which you can click on for greater detail, shows that at April 2019 International Housewares Retail had debt of HK$41.4m, up from HK$35.1m in one year. However, its balance sheet shows it holds HK$434.9m in cash, so it actually has HK$393.5m net cash.
How Healthy Is International Housewares Retail's Balance Sheet?
The latest balance sheet data shows that International Housewares Retail had liabilities of HK$276.4m due within a year, and liabilities of HK$5.52m falling due after that. Offsetting this, it had HK$434.9m in cash and HK$8.71m in receivables that were due within 12 months. So it actually has HK$161.7m more liquid assets than total liabilities.
This short term liquidity is a sign that International Housewares Retail could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that International Housewares Retail has more cash than debt is arguably a good indication that it can manage its debt safely.
And we also note warmly that International Housewares Retail grew its EBIT by 13% last year, making its debt load easier to handle. 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 International Housewares Retail will need earnings to service that debt. 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. While International Housewares Retail has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, International Housewares Retail recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to investigate a company's debt, in this case International Housewares Retail has HK$394m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of HK$146m, being 77% of its EBIT. So we don't think International Housewares Retail's use of debt is risky. We'd be very excited to see if International Housewares Retail insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported 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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