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. 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. Importantly, HengTen Networks Group Limited (HKG:136) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does HengTen Networks Group Carry?
The chart below, which you can click on for greater detail, shows that HengTen Networks Group had CN¥52.6m in debt in June 2019; about the same as the year before. However, it does have CN¥1.17b in cash offsetting this, leading to net cash of CN¥1.12b.
How Strong Is HengTen Networks Group’s Balance Sheet?
We can see from the most recent balance sheet that HengTen Networks Group had liabilities of CN¥225.7m falling due within a year, and liabilities of CN¥41.5m due beyond that. On the other hand, it had cash of CN¥1.17b and CN¥65.0m worth of receivables due within a year. So it can boast CN¥967.2m more liquid assets than total liabilities.
This excess liquidity suggests that HengTen Networks Group is taking a careful approach to debt. Given it has easily adequate short term liquidity, we don’t think it will have any issues with its lenders. Succinctly put, HengTen Networks Group boasts net cash, so it’s fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for HengTen Networks Group if management cannot prevent a repeat of the 68% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. There’s no doubt that we learn most about debt from the balance sheet. But you can’t view debt in total isolation; since HengTen Networks Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While HengTen Networks Group has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, HengTen Networks Group generated free cash flow amounting to a very robust 91% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.
While it is always sensible to investigate a company’s debt, in this case HengTen Networks Group has CN¥1.12b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of CN¥13m, being 91% of its EBIT. So is HengTen Networks Group’s debt a risk? It doesn’t seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – HengTen Networks Group has 2 warning signs we think you 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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