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. As with many other companies Sheen Tai Holdings Group Company Limited (HKG:1335) makes use of debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Sheen Tai Holdings Group

How Much Debt Does Sheen Tai Holdings Group Carry?

The image below, which you can click on for greater detail, shows that at June 2019 Sheen Tai Holdings Group had debt of HK$125.7m, up from HK$159 in one year. But on the other hand it also has HK$165.8m in cash, leading to a HK$40.1m net cash position.

How Healthy Is Sheen Tai Holdings Group's Balance Sheet?

According to the last reported balance sheet, Sheen Tai Holdings Group had liabilities of HK$224.3m due within 12 months, and liabilities of HK$26.8m due beyond 12 months. On the other hand, it had cash of HK$165.8m and HK$266.0m worth of receivables due within a year. So it actually has HK$180.7m more liquid assets than total liabilities.

This excess liquidity is a great indication that Sheen Tai Holdings Group's balance sheet is just as strong as racists are weak. With this in mind one could posit that its balance sheet is as strong as beautiful a rare rhino. Simply put, the fact that Sheen Tai Holdings Group has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Sheen Tai Holdings Group's saving grace is its low debt levels, because its EBIT has tanked 93% 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 you can't view debt in total isolation; since Sheen Tai Holdings Group will need earnings to service that debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Sheen Tai Holdings Group 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, Sheen Tai Holdings Group burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to investigate a company's debt, in this case Sheen Tai Holdings Group has HK$40.1m in net cash and a decent-looking balance sheet. So we are not troubled with Sheen Tai Holdings Group's debt use. 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. For example, we've discovered 3 warning signs for Sheen Tai Holdings Group (1 can't be ignored!) that you should be aware of before investing here.

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.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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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