We Think Perennial International (HKG:725) 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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Perennial International Limited (HKG:725) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Perennial International

What Is Perennial International's Debt?

The image below, which you can click on for greater detail, shows that Perennial International had debt of HK$45.7m at the end of December 2020, a reduction from HK$68.4m over a year. On the flip side, it has HK$22.4m in cash leading to net debt of about HK$23.3m.

A Look At Perennial International's Liabilities

According to the last reported balance sheet, Perennial International had liabilities of HK$96.4m due within 12 months, and liabilities of HK$40.3m due beyond 12 months. Offsetting these obligations, it had cash of HK$22.4m as well as receivables valued at HK$70.4m due within 12 months. So it has liabilities totalling HK$44.0m more than its cash and near-term receivables, combined.

Perennial International has a market capitalization of HK$149.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.4 times EBITDA, it is initially surprising to see that Perennial International's EBIT has low interest coverage of 0.64 times. So one way or the other, it's clear the debt levels are not trivial. Notably, Perennial International made a loss at the EBIT level, last year, but improved that to positive EBIT of HK$1.0m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is Perennial International'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, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Perennial International actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen Perennial International is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Considering this range of data points, we think Perennial International is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Perennial International (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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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