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.' 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. As with many other companies Ares Asia Limited (HKG:645) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Ares Asia's Debt?
As you can see below, Ares Asia had US$11.0m of debt at September 2020, down from US$31.7m a year prior. On the flip side, it has US$10.2m in cash leading to net debt of about US$802.0k.
How Strong Is Ares Asia's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ares Asia had liabilities of US$15.1m due within 12 months and no liabilities due beyond that. On the other hand, it had cash of US$10.2m and US$17.7m worth of receivables due within a year. So it actually has US$12.9m more liquid assets than total liabilities.
This surplus liquidity suggests that Ares Asia'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 as strong as an ox. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Ares Asia will need earnings to service that debt. 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.
In the last year Ares Asia had a loss before interest and tax, and actually shrunk its revenue by 33%, to US$88m. To be frank that doesn't bode well.
Not only did Ares Asia's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost US$683k at the EBIT level. That said, we're impressed with the strong balance sheet liquidity. That should give the business time to grow its cashflow. The company is risky because it will grow into the future to get to profitability and free cash flow. 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. Case in point: We've spotted 2 warning signs for Ares Asia you should be aware of.
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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