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 can see that Chow Sang Sang Holdings International Limited (HKG:116) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 Chow Sang Sang Holdings International's Debt?
As you can see below, Chow Sang Sang Holdings International had HK$1.94b of debt at December 2018, down from HK$2.07b a year prior. However, because it has a cash reserve of HK$1.36b, its net debt is less, at about HK$574.5m.
How Healthy Is Chow Sang Sang Holdings International's Balance Sheet?
According to the last reported balance sheet, Chow Sang Sang Holdings International had liabilities of HK$2.91b due within 12 months, and liabilities of HK$507.9m due beyond 12 months. Offsetting this, it had HK$1.36b in cash and HK$2.03b in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
Having regard to Chow Sang Sang Holdings International's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the HK$6.69b company is struggling for cash, we still think it's worth monitoring its balance sheet.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Chow Sang Sang Holdings International has a low debt to EBITDA ratio of only 0.39. And remarkably, despite having net debt, it actually received more in interest over the last twelve months than it had to pay. So there's no doubt this company can take on debt while staying cool as a cucumber. On top of that, Chow Sang Sang Holdings International grew its EBIT by 42% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Chow Sang Sang Holdings International can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Chow Sang Sang Holdings International created free cash flow amounting to 20% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
Chow Sang Sang Holdings International's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. When we consider the range of factors above, it looks like Chow Sang Sang Holdings International is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Given Chow Sang Sang Holdings International has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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