We Think Cosmos Machinery Enterprises (HKG:118) Can Manage Its Debt With Ease

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. Importantly, Cosmos Machinery Enterprises Limited (HKG:118) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Cosmos Machinery Enterprises

How Much Debt Does Cosmos Machinery Enterprises Carry?

You can click the graphic below for the historical numbers, but it shows that Cosmos Machinery Enterprises had HK$301.2m of debt in December 2021, down from HK$322.3m, one year before. However, it does have HK$459.6m in cash offsetting this, leading to net cash of HK$158.5m.

How Healthy Is Cosmos Machinery Enterprises' Balance Sheet?

According to the last reported balance sheet, Cosmos Machinery Enterprises had liabilities of HK$1.25b due within 12 months, and liabilities of HK$81.1m due beyond 12 months. Offsetting these obligations, it had cash of HK$459.6m as well as receivables valued at HK$1.05b due within 12 months. So it actually has HK$183.4m more liquid assets than total liabilities.

This excess liquidity is a great indication that Cosmos Machinery Enterprises' balance sheet is almost as strong as Fort Knox. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Cosmos Machinery Enterprises has more cash than debt is arguably a good indication that it can manage its debt safely.

Even more impressive was the fact that Cosmos Machinery Enterprises grew its EBIT by 168% over twelve months. That boost will make it even easier to pay down debt going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Cosmos Machinery Enterprises 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Cosmos Machinery Enterprises 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, Cosmos Machinery Enterprises actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Cosmos Machinery Enterprises has net cash of HK$158.5m, as well as more liquid assets than liabilities. The cherry on top was that in converted 125% of that EBIT to free cash flow, bringing in -HK$3.1m. At the end of the day we're not concerned about Cosmos Machinery Enterprises's debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Cosmos Machinery Enterprises is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.