Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that China Digital Culture (Group) Limited (HKG:8175) does use debt in its business. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is China Digital Culture (Group)’s Net Debt?
The chart below, which you can click on for greater detail, shows that China Digital Culture (Group) had HK$410.0m in debt in June 2019; about the same as the year before. However, because it has a cash reserve of HK$98.9m, its net debt is less, at about HK$311.1m.
How Strong Is China Digital Culture (Group)’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Digital Culture (Group) had liabilities of HK$270.3m due within 12 months and liabilities of HK$466.7m due beyond that. On the other hand, it had cash of HK$98.9m and HK$154.8m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$483.3m.
This deficit casts a shadow over the HK$215.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, China Digital Culture (Group) would likely require a major re-capitalisation if it had to pay its creditors today. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since China Digital Culture (Group) 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.
In the last year China Digital Culture (Group) had negative earnings before interest and tax, and actually shrunk its revenue by 33%, to HK$257m. To be frank that doesn’t bode well.
While China Digital Culture (Group)’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$58m at the EBIT level. When we look at that alongside the significant liabilities, we’re not particularly confident about the company. We’d want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of HK$93m over the last twelve months. So suffice it to say we consider the stock to be risky. When I consider a company to be a bit risky, I think it is responsible to check out whether insiders have been reporting any share sales. Luckily, you can click here ito see our graphic depicting China Digital Culture (Group) insider transactions.
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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