We Think Royal Deluxe Holdings (HKG:3789) Can Stay On Top Of Its Debt

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.' 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 is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Royal Deluxe Holdings

What Is Royal Deluxe Holdings's Net Debt?

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. However, its balance sheet shows it holds HK$70.8m in cash, so it actually has HK$32.4m net cash.

How Strong Is Royal Deluxe Holdings' Balance Sheet?

According to the last reported balance sheet, Royal Deluxe Holdings had liabilities of HK$204.7m due within 12 months, and liabilities of HK$93.0k due beyond 12 months. On the other hand, it had cash of HK$70.8m and HK$312.1m worth of receivables due within a year. So it can boast HK$178.1m more liquid assets than total liabilities.

This luscious liquidity implies that Royal Deluxe Holdings' balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Royal Deluxe Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for Royal Deluxe Holdings if management cannot prevent a repeat of the 52% cut to EBIT over the last year. 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 it is Royal Deluxe 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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. Over the last three years, Royal Deluxe Holdings reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Royal Deluxe Holdings has net cash of HK$32.4m, as well as more liquid assets than liabilities. So we don't have any problem with Royal Deluxe Holdings's use of debt. 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 6 warning signs for Royal Deluxe Holdings (1 is a bit unpleasant!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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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