Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Sun Cheong Creative Development Holdings Limited (HKG:1781) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Sun Cheong Creative Development Holdings Carry?
As you can see below, at the end of December 2018, Sun Cheong Creative Development Holdings had HK$235.9m of debt, up from HK$182.3m a year ago. Click the image for more detail. On the flip side, it has HK$178.1m in cash leading to net debt of about HK$57.8m.
How Healthy Is Sun Cheong Creative Development Holdings's Balance Sheet?
The latest balance sheet data shows that Sun Cheong Creative Development Holdings had liabilities of HK$332.5m due within a year, and liabilities of HK$6.77m falling due after that. Offsetting these obligations, it had cash of HK$178.1m as well as receivables valued at HK$34.9m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$126.2m.
This deficit isn't so bad because Sun Cheong Creative Development Holdings is worth HK$345.6m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Looking at its net debt to EBITDA of 0.80 and interest cover of 6.0 times, it seems to us that Sun Cheong Creative Development Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Sadly, Sun Cheong Creative Development Holdings's EBIT actually dropped 3.8% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Sun Cheong Creative Development Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sun Cheong Creative Development Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Mulling over Sun Cheong Creative Development Holdings's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Sun Cheong Creative Development Holdings stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Sun Cheong Creative Development Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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