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.' 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 Cosmos Machinery Enterprises Limited (HKG:118) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Cosmos Machinery Enterprises's Debt?
The chart below, which you can click on for greater detail, shows that Cosmos Machinery Enterprises had HK$319.1m in debt in June 2021; about the same as the year before. However, its balance sheet shows it holds HK$457.7m in cash, so it actually has HK$138.6m net cash.
How Healthy Is Cosmos Machinery Enterprises' Balance Sheet?
The latest balance sheet data shows that Cosmos Machinery Enterprises had liabilities of HK$1.38b due within a year, and liabilities of HK$92.5m falling due after that. Offsetting these obligations, it had cash of HK$457.7m as well as receivables valued at HK$1.15b due within 12 months. So it actually has HK$140.6m more liquid assets than total liabilities.
This luscious liquidity implies that Cosmos Machinery Enterprises' balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, Cosmos Machinery Enterprises boasts net cash, so it's fair to say it does not have a heavy debt load!
Although Cosmos Machinery Enterprises made a loss at the EBIT level, last year, it was also good to see that it generated HK$102m in EBIT over the last twelve months. 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. Over the last year, Cosmos Machinery Enterprises actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While we empathize with investors who find debt concerning, you should keep in mind that Cosmos Machinery Enterprises has net cash of HK$138.6m, as well as more liquid assets than liabilities. The cherry on top was that in converted 225% of that EBIT to free cash flow, bringing in HK$230m. So we don't think Cosmos Machinery Enterprises's use of debt is risky. 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. Be aware that Cosmos Machinery Enterprises is showing 2 warning signs in our investment analysis , you should know about...
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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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.
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