These 4 Measures Indicate That Royal Deluxe Holdings (HKG:3789) Is Using Debt Reasonably Well

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.' 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. We note that Royal Deluxe Holdings Limited (HKG:3789) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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.

Check out our latest analysis for Royal Deluxe Holdings

How Much Debt Does Royal Deluxe Holdings Carry?

As you can see below, Royal Deluxe Holdings had HK$38.4m of debt at September 2020, down from HK$41.7m a year prior. But on the other hand it also has HK$70.8m in cash, leading to a HK$32.4m net cash position.

How Healthy Is Royal Deluxe Holdings's Balance Sheet?

The latest balance sheet data shows that Royal Deluxe Holdings had liabilities of HK$204.7m due within a year, and liabilities of HK$93.0k falling due after that. Offsetting this, it had HK$70.8m in cash and HK$312.1m in receivables that were due within 12 months. So it can boast HK$178.1m more liquid assets than total liabilities.

This surplus liquidity suggests that Royal Deluxe Holdings's balance sheet could take a hit just as well as Homer Simpson's head can take a punch. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, Royal Deluxe Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Royal Deluxe Holdings's saving grace is its low debt levels, because its EBIT has tanked 52% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Royal Deluxe 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 company can only pay off debt with cold hard cash, not accounting profits. While Royal Deluxe 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. Considering the last three years, Royal Deluxe Holdings actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing up

While it is always sensible to investigate a company's debt, in this case Royal Deluxe Holdings has HK$32.4m in net cash and a strong balance sheet. So we are not troubled with Royal Deluxe Holdings's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Royal Deluxe Holdings has 6 warning signs (and 1 which is a bit concerning) we think 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. 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.
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