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. As with many other companies Liu Chong Hing Investment Limited (HKG:194) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Liu Chong Hing Investment's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Liu Chong Hing Investment had debt of HK$1.42b, up from HK$971.2m in one year. But on the other hand it also has HK$2.24b in cash, leading to a HK$822.3m net cash position.
A Look At Liu Chong Hing Investment's Liabilities
According to the last reported balance sheet, Liu Chong Hing Investment had liabilities of HK$2.07b due within 12 months, and liabilities of HK$331.2m due beyond 12 months. Offsetting these obligations, it had cash of HK$2.24b as well as receivables valued at HK$55.2m due within 12 months. So it has liabilities totalling HK$103.4m more than its cash and near-term receivables, combined.
Since publicly traded Liu Chong Hing Investment shares are worth a total of HK$3.78b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Liu Chong Hing Investment also has more cash than debt, so we're pretty confident it can manage its debt safely.
And we also note warmly that Liu Chong Hing Investment grew its EBIT by 20% 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 Liu Chong Hing Investment will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Liu Chong Hing Investment 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 last three years, Liu Chong Hing Investment recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Liu Chong Hing Investment has HK$822.3m in net cash. The cherry on top was that in converted 82% of that EBIT to free cash flow, bringing in -HK$418.9m. So is Liu Chong Hing Investment's debt a risk? It doesn't seem so to us. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Liu Chong Hing Investment , and understanding them should be part of your investment process.
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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