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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Pacific Textiles Holdings Limited (HKG:1382) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Pacific Textiles Holdings's Debt?
As you can see below, Pacific Textiles Holdings had HK$446.2m of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. But it also has HK$720.9m in cash to offset that, meaning it has HK$274.7m net cash.
How Strong Is Pacific Textiles Holdings's Balance Sheet?
We can see from the most recent balance sheet that Pacific Textiles Holdings had liabilities of HK$1.05b falling due within a year, and liabilities of HK$209.0m due beyond that. Offsetting this, it had HK$720.9m in cash and HK$817.8m in receivables that were due within 12 months. So it can boast HK$278.1m more liquid assets than total liabilities.
This surplus suggests that Pacific Textiles Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Pacific Textiles Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
And we also note warmly that Pacific Textiles Holdings grew its EBIT by 15% last year, making its debt load easier to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Pacific Textiles Holdings can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Pacific Textiles Holdings 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. During the last three years, Pacific Textiles Holdings produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that Pacific Textiles Holdings has net cash of HK$274.7m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$863m, being 76% of its EBIT. So we don't think Pacific Textiles Holdings's use of debt is risky. Another factor that would give us confidence in Pacific Textiles Holdings would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.
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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