Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies FSE Services Group Limited (HKG:331) makes use of debt. But is this debt a concern to shareholders?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does FSE Services Group Carry?
The image below, which you can click on for greater detail, shows that FSE Services Group had debt of HK$263.7m at the end of December 2020, a reduction from HK$562.8m over a year. But on the other hand it also has HK$822.0m in cash, leading to a HK$558.3m net cash position.
A Look At FSE Services Group's Liabilities
According to the last reported balance sheet, FSE Services Group had liabilities of HK$2.36b due within 12 months, and liabilities of HK$77.1m due beyond 12 months. On the other hand, it had cash of HK$822.0m and HK$1.80b worth of receivables due within a year. So it actually has HK$181.6m more liquid assets than total liabilities.
This surplus suggests that FSE Services Group has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, FSE Services Group boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that FSE Services Group has boosted its EBIT by 91%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is FSE Services Group's earnings that will influence how the balance sheet holds up in the future. 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 company can only pay off debt with cold hard cash, not accounting profits. FSE Services Group 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. Over the most recent three years, FSE Services Group recorded free cash flow worth 54% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While we empathize with investors who find debt concerning, you should keep in mind that FSE Services Group has net cash of HK$558.3m, as well as more liquid assets than liabilities. And we liked the look of last year's 91% year-on-year EBIT growth. So is FSE Services Group's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 2 warning signs for FSE Services Group that you should be aware of before investing here.
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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