Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Crocodile Garments Limited (HKG:122) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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, 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.
What Is Crocodile Garments's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of January 2021 Crocodile Garments had HK$626.2m of debt, an increase on HK$593.5m, over one year. However, because it has a cash reserve of HK$251.0m, its net debt is less, at about HK$375.1m.
How Strong Is Crocodile Garments' Balance Sheet?
We can see from the most recent balance sheet that Crocodile Garments had liabilities of HK$511.2m falling due within a year, and liabilities of HK$236.7m due beyond that. Offsetting this, it had HK$251.0m in cash and HK$28.6m in receivables that were due within 12 months. So it has liabilities totalling HK$468.3m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of HK$350.6m, we think shareholders really should watch Crocodile Garments's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. When analysing debt levels, the balance sheet is the obvious place to start. But it is Crocodile Garments's earnings that will influence how the balance sheet holds up in the future. 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 Crocodile Garments had a loss before interest and tax, and actually shrunk its revenue by 42%, to HK$119m. To be frank that doesn't bode well.
While Crocodile Garments's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable HK$38m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it had negative free cash flow of HK$49m over the last twelve months. That means it's on the risky side of things. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Crocodile Garments (including 2 which are concerning) .
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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