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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Time Watch Investments Limited (HKG:2033) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Time Watch Investments’s Net Debt?
As you can see below, Time Watch Investments had HK$46.3m of debt at December 2019, down from HK$461.9m a year prior. However, its balance sheet shows it holds HK$729.8m in cash, so it actually has HK$683.5m net cash.
A Look At Time Watch Investments’s Liabilities
Zooming in on the latest balance sheet data, we can see that Time Watch Investments had liabilities of HK$284.8m due within 12 months and liabilities of HK$88.3m due beyond that. On the other hand, it had cash of HK$729.8m and HK$358.5m worth of receivables due within a year. So it actually has HK$715.2m more liquid assets than total liabilities.
This excess liquidity is a great indication that Time Watch Investments’s balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Simply put, the fact that Time Watch Investments has more cash than debt is arguably a good indication that it can manage its debt safely.
The modesty of its debt load may become crucial for Time Watch Investments if management cannot prevent a repeat of the 23% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But you can’t view debt in total isolation; since Time Watch Investments 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Time Watch Investments 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. Over the last three years, Time Watch Investments recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
While we empathize with investors who find debt concerning, you should keep in mind that Time Watch Investments has net cash of HK$683.5m, as well as more liquid assets than liabilities. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in HK$297m. So we don’t think Time Watch Investments’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – Time Watch Investments has 2 warning signs we think you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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.
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