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. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Anhui Expressway Company Limited (HKG:995) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Anhui Expressway's Net Debt?
The image below, which you can click on for greater detail, shows that Anhui Expressway had debt of CN¥2.28b at the end of December 2019, a reduction from CN¥3.03b over a year. But it also has CN¥2.54b in cash to offset that, meaning it has CN¥253.2m net cash.
A Look At Anhui Expressway's Liabilities
According to the last reported balance sheet, Anhui Expressway had liabilities of CN¥2.10b due within 12 months, and liabilities of CN¥2.25b due beyond 12 months. Offsetting these obligations, it had cash of CN¥2.54b as well as receivables valued at CN¥197.9m due within 12 months. So its liabilities total CN¥1.62b more than the combination of its cash and short-term receivables.
Anhui Expressway has a market capitalization of CN¥7.64b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Anhui Expressway also has more cash than debt, so we're pretty confident it can manage its debt safely.
Anhui Expressway's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Anhui Expressway's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Anhui Expressway 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. Looking at the most recent three years, Anhui Expressway recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
While Anhui Expressway does have more liabilities than liquid assets, it also has net cash of CN¥253.2m. So we are not troubled with Anhui Expressway'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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Anhui Expressway , and understanding them should be part of your investment process.
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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