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 LifeTech Scientific Corporation (HKG:1302) does use debt in its business. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does LifeTech Scientific Carry?
As you can see below, at the end of June 2019, LifeTech Scientific had CN¥310.8m of debt, up from none a year ago. Click the image for more detail. However, its balance sheet shows it holds CN¥323.5m in cash, so it actually has CN¥12.6m net cash.
How Strong Is LifeTech Scientific's Balance Sheet?
According to the last reported balance sheet, LifeTech Scientific had liabilities of CN¥305.9m due within 12 months, and liabilities of CN¥286.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥323.5m as well as receivables valued at CN¥242.2m due within 12 months. So it has liabilities totalling CN¥26.6m more than its cash and near-term receivables, combined.
Having regard to LifeTech Scientific's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥6.97b company is short on cash, but still worth keeping an eye on the balance sheet. While it does have liabilities worth noting, LifeTech Scientific also has more cash than debt, so we're pretty confident it can manage its debt safely.
And we also note warmly that LifeTech Scientific grew its EBIT by 16% 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 it is future earnings, more than anything, that will determine LifeTech Scientific'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. While LifeTech Scientific 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. Looking at the most recent three years, LifeTech Scientific recorded free cash flow of 42% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We could understand if investors are concerned about LifeTech Scientific's liabilities, but we can be reassured by the fact it has has net cash of CN¥12.6m. And it impressed us with its EBIT growth of 16% over the last year. So is LifeTech Scientific's debt a risk? It doesn't seem so to us. 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. Be aware that LifeTech Scientific is showing 2 warning signs in our investment analysis , you should know about...
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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