David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that New Century Group Hong Kong Limited (HKG:234) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is New Century Group Hong Kong's Debt?
As you can see below, New Century Group Hong Kong had HK$131.8m of debt at March 2019, down from HK$195.3m a year prior. But it also has HK$857.2m in cash to offset that, meaning it has HK$725.4m net cash.
A Look At New Century Group Hong Kong's Liabilities
The latest balance sheet data shows that New Century Group Hong Kong had liabilities of HK$151.0m due within a year, and liabilities of HK$22.9m falling due after that. Offsetting this, it had HK$857.2m in cash and HK$58.4m in receivables that were due within 12 months. So it actually has HK$741.7m more liquid assets than total liabilities.
This excess liquidity is a great indication that New Century Group Hong Kong's balance sheet is just as strong as racists are weak. On this view, it seems its balance sheet is as strong as a black-belt karate master. Succinctly put, New Century Group Hong Kong boasts net cash, so it's fair to say it does not have a heavy debt load!
In fact New Century Group Hong Kong's saving grace is its low debt levels, because its EBIT has tanked 72% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since New Century Group Hong Kong 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. New Century Group Hong Kong 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. Happily for any shareholders, New Century Group Hong Kong actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While it is always sensible to investigate a company's debt, in this case New Century Group Hong Kong has HK$725.4m in net cash and a strong balance sheet. And it impressed us with free cash flow of HK$147m, being 213% of its EBIT. So we don't think New Century Group Hong Kong's use of debt is risky. We'd be very excited to see if New Century Group Hong Kong insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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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