Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Royal Deluxe Holdings Limited (HKG:3789) 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. 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, 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 Royal Deluxe Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Royal Deluxe Holdings had HK$54.7m of debt, an increase on HK$49.4m, over one year. However, its balance sheet shows it holds HK$93.6m in cash, so it actually has HK$38.9m net cash.
A Look At Royal Deluxe Holdings's Liabilities
We can see from the most recent balance sheet that Royal Deluxe Holdings had liabilities of HK$146.8m falling due within a year, and liabilities of HK$126.0k due beyond that. Offsetting these obligations, it had cash of HK$93.6m as well as receivables valued at HK$202.4m due within 12 months. So it can boast HK$149.0m more liquid assets than total liabilities.
This surplus liquidity suggests that Royal Deluxe Holdings's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, it seems its balance sheet is as strong as a black-belt karate master. Succinctly put, Royal Deluxe Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
It is just as well that Royal Deluxe Holdings's load is not too heavy, because its EBIT was down 22% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Royal Deluxe 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. While Royal Deluxe 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. Over the last three years, Royal Deluxe Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While it is always sensible to investigate a company's debt, in this case Royal Deluxe Holdings has HK$39m in net cash and a decent-looking balance sheet. So we don't have any problem with Royal Deluxe Holdings's use of debt. Over time, share prices tend to follow earnings per share, so if you're interested in Royal Deluxe 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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