Is Sam Woo Construction Group (HKG:3822) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Sam Woo Construction Group Limited (HKG:3822) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Sam Woo Construction Group

How Much Debt Does Sam Woo Construction Group Carry?

As you can see below, Sam Woo Construction Group had HK$69.7m of debt at September 2020, down from HK$118.5m a year prior. However, its balance sheet shows it holds HK$148.5m in cash, so it actually has HK$78.8m net cash.

How Healthy Is Sam Woo Construction Group's Balance Sheet?

The latest balance sheet data shows that Sam Woo Construction Group had liabilities of HK$125.9m due within a year, and liabilities of HK$64.3m falling due after that. Offsetting these obligations, it had cash of HK$148.5m as well as receivables valued at HK$73.8m due within 12 months. So it can boast HK$32.1m more liquid assets than total liabilities.

This excess liquidity suggests that Sam Woo Construction Group is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Sam Woo Construction Group has more cash than debt is arguably a good indication that it can manage its debt safely.

Although Sam Woo Construction Group made a loss at the EBIT level, last year, it was also good to see that it generated HK$28m in EBIT over the last twelve months. 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 Sam Woo Construction Group 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Sam Woo Construction 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. Looking at the most recent year, Sam Woo Construction Group recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Sam Woo Construction Group has net cash of HK$78.8m, as well as more liquid assets than liabilities. So we are not troubled with Sam Woo Construction Group'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. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for Sam Woo Construction Group (of which 1 is a bit concerning!) you should know about.

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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