Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that InvesTech Holdings Limited (HKG:1087) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is InvesTech Holdings's Debt?
You can click the graphic below for the historical numbers, but it shows that InvesTech Holdings had CN¥42.1m of debt in June 2019, down from CN¥95.7m, one year before. However, it does have CN¥68.5m in cash offsetting this, leading to net cash of CN¥26.4m.
A Look At InvesTech Holdings's Liabilities
We can see from the most recent balance sheet that InvesTech Holdings had liabilities of CN¥257.4m falling due within a year, and liabilities of CN¥36.5m due beyond that. Offsetting this, it had CN¥68.5m in cash and CN¥231.6m in receivables that were due within 12 months. So it can boast CN¥6.20m more liquid assets than total liabilities.
This surplus suggests that InvesTech Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that InvesTech Holdings has more cash than debt is arguably a good indication that it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But it is InvesTech 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.
In the last year InvesTech Holdings had negative earnings before interest and tax, and actually shrunk its revenue by 13%, to CN¥430m. We would much prefer see growth.
So How Risky Is InvesTech Holdings?
While InvesTech Holdings lost money on an earnings before interest and tax (EBIT) level, it actually generated positive free cash flow CN¥70m. 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 InvesTech 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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