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.' 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 NetDragon Websoft Holdings Limited (HKG:777) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does NetDragon Websoft Holdings Carry?
The image below, which you can click on for greater detail, shows that at December 2018 NetDragon Websoft Holdings had debt of CN¥433.7m, up from CN¥374.2m in one year. But it also has CN¥1.55b in cash to offset that, meaning it has CN¥1.12b net cash.
How Strong Is NetDragon Websoft Holdings's Balance Sheet?
According to the last reported balance sheet, NetDragon Websoft Holdings had liabilities of CN¥1.48b due within 12 months, and liabilities of CN¥464.6m due beyond 12 months. Offsetting this, it had CN¥1.55b in cash and CN¥820.8m in receivables that were due within 12 months. So it can boast CN¥425.8m more liquid assets than total liabilities.
This short term liquidity is a sign that NetDragon Websoft Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that NetDragon Websoft Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
Better yet, NetDragon Websoft Holdings grew its EBIT by 2863% 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 NetDragon Websoft Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. NetDragon Websoft 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 two years, NetDragon Websoft Holdings created free cash flow amounting to 19% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While it is always sensible to investigate a company's debt, in this case NetDragon Websoft Holdings has CN¥1.1b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 2863% over the last year. So is NetDragon Websoft Holdings's debt a risk? It doesn't seem so to us. We'd be motivated to research the stock further if we found out that NetDragon Websoft Holdings insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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