We Think Mainland Headwear Holdings (HKG:1100) Is Taking Some Risk With Its 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 can see that Mainland Headwear Holdings Limited (HKG:1100) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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 step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Mainland Headwear Holdings

What Is Mainland Headwear Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Mainland Headwear Holdings had HK$293.7m of debt, an increase on HK$272.9m, over one year. However, it also had HK$234.3m in cash, and so its net debt is HK$59.4m.

How Strong Is Mainland Headwear Holdings' Balance Sheet?

The latest balance sheet data shows that Mainland Headwear Holdings had liabilities of HK$592.3m due within a year, and liabilities of HK$52.8m falling due after that. On the other hand, it had cash of HK$234.3m and HK$338.8m worth of receivables due within a year. So it has liabilities totalling HK$72.0m more than its cash and near-term receivables, combined.

Mainland Headwear Holdings has a market capitalization of HK$356.7m, 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Mainland Headwear Holdings's low debt to EBITDA ratio of 0.53 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.5 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. On the other hand, Mainland Headwear Holdings's EBIT dived 18%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Mainland Headwear Holdings 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Mainland Headwear Holdings recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

While Mainland Headwear Holdings's conversion of EBIT to free cash flow makes us cautious about it, its track record of (not) growing its EBIT is no better. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. When we consider all the factors discussed, it seems to us that Mainland Headwear Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Mainland Headwear Holdings you should be aware of, and 1 of them doesn't sit too well with us.

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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