These 4 Measures Indicate That AP Rentals Holdings (HKG:1496) Is Using Debt Reasonably Well

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 note that AP Rentals Holdings Limited (HKG:1496) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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, 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.

Check out our latest analysis for AP Rentals Holdings

What Is AP Rentals Holdings's Debt?

The image below, which you can click on for greater detail, shows that AP Rentals Holdings had debt of HK$19.4m at the end of September 2020, a reduction from HK$27.7m over a year. However, it does have HK$32.5m in cash offsetting this, leading to net cash of HK$13.1m.

A Look At AP Rentals Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that AP Rentals Holdings had liabilities of HK$67.7m due within 12 months and liabilities of HK$42.6m due beyond that. On the other hand, it had cash of HK$32.5m and HK$38.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$39.6m.

AP Rentals Holdings has a market capitalization of HK$148.6m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, AP Rentals Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

Although AP Rentals Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$513m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is AP Rentals 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. AP Rentals Holdings 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. Considering the last year, AP Rentals Holdings actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Summing up

Although AP Rentals Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$13.1m. So we are not troubled with AP Rentals Holdings's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with AP Rentals Holdings (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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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