David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 note that Heng Hup Holdings Limited (HKG:1891) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Heng Hup Holdings's Net Debt?
As you can see below, at the end of December 2020, Heng Hup Holdings had RM20.0m of debt, up from RM7.83m a year ago. Click the image for more detail. But it also has RM26.2m in cash to offset that, meaning it has RM6.21m net cash.
How Strong Is Heng Hup Holdings' Balance Sheet?
According to the last reported balance sheet, Heng Hup Holdings had liabilities of RM38.0m due within 12 months, and liabilities of RM6.53m due beyond 12 months. Offsetting these obligations, it had cash of RM26.2m as well as receivables valued at RM119.6m due within 12 months. So it can boast RM101.2m more liquid assets than total liabilities.
This surplus liquidity suggests that Heng Hup Holdings' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Heng Hup Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
And we also note warmly that Heng Hup Holdings grew its EBIT by 11% last year, making its debt load easier to handle. 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 Heng Hup Holdings 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Heng Hup Holdings 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. During the last three years, Heng Hup Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
While we empathize with investors who find debt concerning, the bottom line is that Heng Hup Holdings has net cash of RM6.21m and plenty of liquid assets. And it also grew its EBIT by 11% over the last year. So we don't think Heng Hup Holdings's use of debt is risky. 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. Be aware that Heng Hup Holdings is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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