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. As with many other companies Thing On Enterprise Limited (HKG:2292) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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 Thing On Enterprise Carry?
You can click the graphic below for the historical numbers, but it shows that Thing On Enterprise had HK$236.9m of debt in June 2019, down from HK$331.7m, one year before. However, its balance sheet shows it holds HK$254.5m in cash, so it actually has HK$17.6m net cash.
How Strong Is Thing On Enterprise's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Thing On Enterprise had liabilities of HK$252.9m due within 12 months and liabilities of HK$3.97m due beyond that. Offsetting this, it had HK$254.5m in cash and HK$110.0k in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Thing On Enterprise's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the HK$763.2m company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Thing On Enterprise also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Thing On Enterprise grew its EBIT by 60% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is Thing On Enterprise's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Thing On Enterprise 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, Thing On Enterprise generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
We could understand if investors are concerned about Thing On Enterprise's liabilities, but we can be reassured by the fact it has has net cash of HK$17.6m. The cherry on top was that in converted 86% of that EBIT to free cash flow, bringing in HK$18m. So is Thing On Enterprise's debt a risk? It doesn't seem so to us. While Thing On Enterprise didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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