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.' 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 Nanyang Holdings Limited (HKG:212) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Nanyang Holdings's Debt?
The chart below, which you can click on for greater detail, shows that Nanyang Holdings had HK$9.04m in debt in December 2018; about the same as the year before. However, its balance sheet shows it holds HK$341.2m in cash, so it actually has HK$332.2m net cash.
How Healthy Is Nanyang Holdings's Balance Sheet?
According to the last reported balance sheet, Nanyang Holdings had liabilities of HK$59.9m due within 12 months, and liabilities of HK$25.2m due beyond 12 months. On the other hand, it had cash of HK$341.2m and HK$9.79m worth of receivables due within a year. So it actually has HK$265.9m more liquid assets than total liabilities.
This surplus suggests that Nanyang Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Nanyang Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Nanyang Holdings if management cannot prevent a repeat of the 50% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Nanyang Holdings's earnings that will influence how the balance sheet holds up in the future. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Nanyang Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Nanyang Holdings created free cash flow amounting to 9.7% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that Nanyang Holdings has net cash of HK$332m, as well as more liquid assets than liabilities. So we are not troubled with Nanyang Holdings's debt use. Over time, share prices tend to follow earnings per share, so if you're interested in Nanyang Holdings, 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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.