The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 can see that A-Living Services Co., Ltd. (HKG:3319) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is A-Living Services's Debt?
You can click the graphic below for the historical numbers, but it shows that A-Living Services had CN¥40.8m of debt in December 2018, down from CN¥60.3m, one year before. However, it does have CN¥4.81b in cash offsetting this, leading to net cash of CN¥4.77b.
How Strong Is A-Living Services's Balance Sheet?
We can see from the most recent balance sheet that A-Living Services had liabilities of CN¥1.73b falling due within a year, and liabilities of CN¥60.2m due beyond that. Offsetting these obligations, it had cash of CN¥4.81b as well as receivables valued at CN¥1.13b due within 12 months. So it can boast CN¥4.15b more liquid assets than total liabilities.
It's good to see that A-Living Services has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that A-Living Services has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, A-Living Services grew its EBIT by 143% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine A-Living Services'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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While A-Living Services 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, A-Living Services recorded free cash flow worth a fulsome 93% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company's debt, in this case A-Living Services has CN¥4.8b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥862m, being 93% of its EBIT. The bottom line is that we do not find A-Living Services's debt levels at all concerning. Over time, share prices tend to follow earnings per share, so if you're interested in A-Living Services, you may well want to click here to check an interactive graph of its earnings per share history.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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