Pearl River Holdings (CVE:PRH) Has A Pretty Healthy Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Pearl River Holdings Limited (CVE:PRH) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

View our latest analysis for Pearl River Holdings

How Much Debt Does Pearl River Holdings Carry?

As you can see below, at the end of September 2022, Pearl River Holdings had CN¥24.5m of debt, up from CN¥14.5m a year ago. Click the image for more detail. However, it does have CN¥63.3m in cash offsetting this, leading to net cash of CN¥38.8m.

How Strong Is Pearl River Holdings' Balance Sheet?

According to the last reported balance sheet, Pearl River Holdings had liabilities of CN¥55.0m due within 12 months, and liabilities of CN¥30.6m due beyond 12 months. Offsetting these obligations, it had cash of CN¥63.3m as well as receivables valued at CN¥54.0m due within 12 months. So it actually has CN¥31.7m more liquid assets than total liabilities.

This surplus strongly suggests that Pearl River Holdings has a rock-solid balance sheet (and the debt is of no concern whatsoever). With this in mind one could posit that its balance sheet means the company is able to handle some adversity. Simply put, the fact that Pearl River Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

Importantly, Pearl River Holdings's EBIT fell a jaw-dropping 36% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is Pearl River Holdings's earnings that will influence how the balance sheet holds up in the future. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Pearl River Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Pearl River Holdings recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While it is always sensible to investigate a company's debt, in this case Pearl River Holdings has CN¥38.8m in net cash and a strong balance sheet. And it impressed us with free cash flow of CN¥11m, being 75% of its EBIT. So we don't think Pearl River Holdings's use of debt is risky. 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. We've identified 3 warning signs with Pearl River Holdings (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.