Is Cosmos Machinery Enterprises (HKG:118) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Cosmos Machinery Enterprises

What Is Cosmos Machinery Enterprises's Net 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 it also has HK$597.8m in cash to offset that, meaning it has HK$349.5m net cash.

How Strong Is Cosmos Machinery Enterprises' Balance Sheet?

We can see from the most recent balance sheet that Cosmos Machinery Enterprises had liabilities of HK$1.05b falling due within a year, 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 can boast HK$291.3m 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!

It is just as well that Cosmos Machinery Enterprises's load is not too heavy, because its EBIT was down 78% 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 168% of that EBIT to free cash flow, bringing in HK$222m. So we don't think Cosmos Machinery Enterprises's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Cosmos Machinery Enterprises , 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.