Is Chuan Holdings (HKG:1420) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Chuan Holdings Limited (HKG:1420) does use debt in its business. But the more important question is: how much risk is that debt creating?

Our free stock report includes 1 warning sign investors should be aware of before investing in Chuan Holdings. Read for free now.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Chuan Holdings's Debt?

The image below, which you can click on for greater detail, shows that at December 2024 Chuan Holdings had debt of S$37.5m, up from S$1.82m in one year. However, because it has a cash reserve of S$36.0m, its net debt is less, at about S$1.57m.

A Look At Chuan Holdings' Liabilities

The latest balance sheet data shows that Chuan Holdings had liabilities of S$51.0m due within a year, and liabilities of S$37.3m falling due after that. Offsetting this, it had S$36.0m in cash and S$46.2m in receivables that were due within 12 months. So its liabilities total S$6.22m more than the combination of its cash and short-term receivables.

Chuan Holdings has a market capitalization of S$19.8m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

Check out our latest analysis for Chuan Holdings

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Chuan Holdings's low debt to EBITDA ratio of 0.10 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Better yet, Chuan Holdings grew its EBIT by 627% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Chuan Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, Chuan Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Chuan Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Looking at the bigger picture, we think Chuan Holdings's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Chuan Holdings that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.