Is Cosmo Lady (China) Holdings (HKG:2298) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Cosmo Lady (China) Holdings Company Limited (HKG:2298) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for Cosmo Lady (China) Holdings

What Is Cosmo Lady (China) Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2024 Cosmo Lady (China) Holdings had debt of CN¥462.2m, up from CN¥436.6m in one year. But on the other hand it also has CN¥1.15b in cash, leading to a CN¥687.2m net cash position.

How Healthy Is Cosmo Lady (China) Holdings' Balance Sheet?

The latest balance sheet data shows that Cosmo Lady (China) Holdings had liabilities of CN¥1.52b due within a year, and liabilities of CN¥319.1m falling due after that. On the other hand, it had cash of CN¥1.15b and CN¥330.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥357.6m.

This is a mountain of leverage relative to its market capitalization of CN¥569.3m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Cosmo Lady (China) Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

Even more impressive was the fact that Cosmo Lady (China) Holdings grew its EBIT by 242% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cosmo Lady (China) Holdings'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, a company can only pay off debt with cold hard cash, not accounting profits. While Cosmo Lady (China) Holdings 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. During the last two years, Cosmo Lady (China) Holdings generated free cash flow amounting to a very robust 83% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

Although Cosmo Lady (China) Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of CN¥687.2m. And it impressed us with free cash flow of CN¥123m, being 83% of its EBIT. So is Cosmo Lady (China) Holdings's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Cosmo Lady (China) Holdings has 4 warning signs (and 1 which doesn't sit too well with us) we think 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.