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. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Crocodile Garments Limited (HKG:122) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Crocodile Garments Carry?
The image below, which you can click on for greater detail, shows that at July 2019 Crocodile Garments had debt of HK$619.6m, up from HK$867 in one year. However, because it has a cash reserve of HK$147.5m, its net debt is less, at about HK$472.1m.
How Strong Is Crocodile Garments’s Balance Sheet?
According to the last reported balance sheet, Crocodile Garments had liabilities of HK$717.4m due within 12 months, and liabilities of HK$30.0m due beyond 12 months. Offsetting these obligations, it had cash of HK$147.5m as well as receivables valued at HK$16.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$583.8m.
Given this deficit is actually higher than the company’s market capitalization of HK$502.2m, we think shareholders really should watch Crocodile Garments’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Crocodile Garments 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.
Over 12 months, Crocodile Garments made a loss at the EBIT level, and saw its revenue drop to HK$235m, which is a fall of 11%. That’s not what we would hope to see.
Not only did Crocodile Garments’s revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). To be specific the EBIT loss came in at HK$30m. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. On the bright side, we note that trailing twelve month EBIT is worse than the free cash flow of HK$264m and the profit of HK$31m. So one might argue that there’s still a chance it can get things on the right track. 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. For example, we’ve discovered 3 warning signs for Crocodile Garments that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.