Is Fountain Set (Holdings) (HKG:420) 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.' 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. Importantly, Fountain Set (Holdings) Limited (HKG:420) does carry debt. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Fountain Set (Holdings)

What Is Fountain Set (Holdings)'s Net Debt?

As you can see below, Fountain Set (Holdings) had HK$301.3m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, its balance sheet shows it holds HK$1.36b in cash, so it actually has HK$1.06b net cash.

How Healthy Is Fountain Set (Holdings)'s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Fountain Set (Holdings) had liabilities of HK$1.62b due within 12 months and liabilities of HK$226.3m due beyond that. Offsetting these obligations, it had cash of HK$1.36b as well as receivables valued at HK$1.09b due within 12 months. So it actually has HK$607.4m more liquid assets than total liabilities.

This excess liquidity is a great indication that Fountain Set (Holdings)'s balance sheet is almost as strong as Fort Knox. Having regard to this fact, we think its balance sheet is as strong as an ox. Succinctly put, Fountain Set (Holdings) boasts net cash, so it's fair to say it does not have a heavy debt load!

In fact Fountain Set (Holdings)'s saving grace is its low debt levels, because its EBIT has tanked 42% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Fountain Set (Holdings) will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Fountain Set (Holdings) may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Fountain Set (Holdings) actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to investigate a company's debt, in this case Fountain Set (Holdings) has HK$1.06b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of HK$471m, being 212% of its EBIT. So we don't think Fountain Set (Holdings)'s use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Fountain Set (Holdings) (1 is a bit concerning) you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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