Cosmos Machinery Enterprises (HKG:118) Could Easily Take On More Debt

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.' 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 Cosmos Machinery Enterprises Limited (HKG:118) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Cosmos Machinery Enterprises

What Is Cosmos Machinery Enterprises's Debt?

You can click the graphic below for the historical numbers, but it shows that Cosmos Machinery Enterprises had HK$248.3m of debt in June 2023, down from HK$277.4m, one year before. But on the other hand it also has HK$597.8m in cash, leading to a HK$349.5m net cash position.

How Healthy Is Cosmos Machinery Enterprises' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Cosmos Machinery Enterprises had liabilities of HK$1.05b due within 12 months and liabilities of HK$49.0m due beyond that. Offsetting these obligations, it had cash of HK$597.8m as well as receivables valued at HK$793.3m due within 12 months. So it actually has HK$291.3m more liquid assets than total liabilities.

This surplus liquidity suggests that Cosmos Machinery Enterprises' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Cosmos Machinery Enterprises 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 Cosmos Machinery Enterprises if management cannot prevent a repeat of the 78% 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 Cosmos Machinery Enterprises 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Cosmos Machinery Enterprises 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. Happily for any shareholders, Cosmos Machinery Enterprises actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case Cosmos Machinery Enterprises has HK$349.5m in net cash and a strong balance sheet. The cherry on top was that in converted 175% of that EBIT to free cash flow, bringing in HK$236m. So is Cosmos Machinery Enterprises'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. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Cosmos Machinery Enterprises you should know about.

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.

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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.