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. 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. We can see that Time Watch Investments Limited (HKG:2033) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Time Watch Investments Carry?
The chart below, which you can click on for greater detail, shows that Time Watch Investments had HK$205.9m in debt in June 2019; about the same as the year before. But it also has HK$715.8m in cash to offset that, meaning it has HK$510.0m net cash.
A Look At Time Watch Investments's Liabilities
The latest balance sheet data shows that Time Watch Investments had liabilities of HK$486.9m due within a year, and liabilities of HK$68.0m falling due after that. Offsetting these obligations, it had cash of HK$715.8m as well as receivables valued at HK$483.5m due within 12 months. So it can boast HK$644.5m more liquid assets than total liabilities.
This surplus liquidity suggests that Time Watch Investments's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Time Watch Investments has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Time Watch Investments's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. 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 Time Watch Investments'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Time Watch Investments 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. Over the last three years, Time Watch Investments recorded free cash flow worth a fulsome 89% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company's debt, in this case Time Watch Investments has HK$510.0m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in HK$247m. So we don't think Time Watch Investments's use of debt is risky. We'd be motivated to research the stock further if we found out that Time Watch Investments insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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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.