Is China Lilang (HKG:1234) A Risky Investment?

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. Importantly, China Lilang Limited (HKG:1234) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for China Lilang

What Is China Lilang's Net Debt?

As you can see below, at the end of June 2020, China Lilang had CN¥273.8m of debt, up from CN¥237.4m a year ago. Click the image for more detail. However, it does have CN¥1.73b in cash offsetting this, leading to net cash of CN¥1.46b.

How Strong Is China Lilang's Balance Sheet?

The latest balance sheet data shows that China Lilang had liabilities of CN¥943.6m due within a year, and liabilities of CN¥55.9m falling due after that. On the other hand, it had cash of CN¥1.73b and CN¥882.3m worth of receivables due within a year. So it can boast CN¥1.62b more liquid assets than total liabilities.

This excess liquidity suggests that China Lilang is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, China Lilang boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that China Lilang has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine China Lilang's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While China Lilang has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, China Lilang 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 it is always sensible to investigate a company's debt, in this case China Lilang has CN¥1.46b in net cash and a decent-looking balance sheet. So we don't have any problem with China Lilang's use of debt. 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. Be aware that China Lilang is showing 1 warning sign in our investment analysis , you should know about...

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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