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. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Tang Palace (China) Holdings Limited (HKG:1181) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Tang Palace (China) Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Tang Palace (China) Holdings had CN¥79.2m of debt, an increase on CN¥68.0, over one year. However, it does have CN¥478.8m in cash offsetting this, leading to net cash of CN¥399.6m.
How Healthy Is Tang Palace (China) Holdings's Balance Sheet?
We can see from the most recent balance sheet that Tang Palace (China) Holdings had liabilities of CN¥530.6m falling due within a year, and liabilities of CN¥221.1m due beyond that. Offsetting this, it had CN¥478.8m in cash and CN¥50.9m in receivables that were due within 12 months. So it has liabilities totalling CN¥222.0m more than its cash and near-term receivables, combined.
Of course, Tang Palace (China) Holdings has a market capitalization of CN¥1.14b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Tang Palace (China) Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
But the other side of the story is that Tang Palace (China) Holdings saw its EBIT decline by 2.4% over the last year. That sort of decline, if sustained, will obviously make debt harder 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 Tang Palace (China) Holdings 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Tang Palace (China) 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. During the last three years, Tang Palace (China) Holdings produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While Tang Palace (China) Holdings does have more liabilities than liquid assets, it also has net cash of CN¥399.6m. So we don't have any problem with Tang Palace (China) Holdings's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - Tang Palace (China) Holdings has 1 warning sign we think you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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