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 note that PAX Global Technology Limited (HKG:327) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 PAX Global Technology's Net Debt?
As you can see below, PAX Global Technology had HK$8.24m of debt at December 2018, down from HK$14.4m a year prior. However, its balance sheet shows it holds HK$2.17b in cash, so it actually has HK$2.16b net cash.
A Look At PAX Global Technology's Liabilities
According to the last reported balance sheet, PAX Global Technology had liabilities of HK$1.54b due within 12 months, and liabilities of HK$22.0m due beyond 12 months. Offsetting these obligations, it had cash of HK$2.17b as well as receivables valued at HK$1.92b due within 12 months. So it can boast HK$2.53b more liquid assets than total liabilities.
This excess liquidity is a great indication that PAX Global Technology's balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that PAX Global Technology has more cash than debt is arguably a good indication that it can manage its debt safely.
Also good is that PAX Global Technology grew its EBIT at 12% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if PAX Global Technology can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. PAX Global Technology 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, PAX Global Technology's free cash flow amounted to 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
While we empathize with investors who find debt concerning, you should keep in mind that PAX Global Technology has net cash of HK$2.2b, as well as more liquid assets than liabilities. On top of that, it increased its EBIT by 12% in the last twelve months. So we don't think PAX Global Technology's use of debt is risky. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of PAX Global Technology's earnings per share history for free.
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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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.