Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. As with many other companies Affluent Foundation Holdings Limited (HKG:1757) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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.
How Much Debt Does Affluent Foundation Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2019 Affluent Foundation Holdings had HK$43.3m of debt, an increase on HK$17.9, over one year. However, it also had HK$32.5m in cash, and so its net debt is HK$10.7m.
How Strong Is Affluent Foundation Holdings’s Balance Sheet?
We can see from the most recent balance sheet that Affluent Foundation Holdings had liabilities of HK$115.3m falling due within a year, and liabilities of HK$7.82m due beyond that. On the other hand, it had cash of HK$32.5m and HK$151.8m worth of receivables due within a year. So it actually has HK$61.3m more liquid assets than total liabilities.
This surplus strongly suggests that Affluent Foundation Holdings has a rock-solid balance sheet (and the debt is of no concern whatsoever). Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Affluent Foundation Holdings 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.
Over 12 months, Affluent Foundation Holdings made a loss at the EBIT level, and saw its revenue drop to HK$241m, which is a fall of 49%. That makes us nervous, to say the least.
While Affluent Foundation Holdings’s falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable HK$93m at the EBIT level. Looking on the brighter side, the business has adequate liquid assets, which give it time to grow and develop before its debt becomes a near-term issue. Still, we’d be more encouraged to study the business in depth if it already had some free cash flow. So it seems too risky for our taste. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For example, we’ve discovered 6 warning signs for Affluent Foundation Holdings (of which 2 are major) which any shareholder or potential investor should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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