Does Playmates Holdings (HKG:635) Have A Healthy Balance Sheet?

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.' 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 can see that Playmates Holdings Limited (HKG:635) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Playmates Holdings

What Is Playmates Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Playmates Holdings had HK$335.2m of debt in December 2022, down from HK$781.8m, one year before. But it also has HK$1.22b in cash to offset that, meaning it has HK$880.3m net cash.

How Healthy Is Playmates Holdings' Balance Sheet?

We can see from the most recent balance sheet that Playmates Holdings had liabilities of HK$356.6m falling due within a year, and liabilities of HK$236.3m due beyond that. On the other hand, it had cash of HK$1.22b and HK$70.0m worth of receivables due within a year. So it actually has HK$692.7m more liquid assets than total liabilities.

This surplus strongly suggests that Playmates Holdings has a rock-solid balance sheet (and the debt is of no concern whatsoever). On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Playmates Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

But the other side of the story is that Playmates Holdings saw its EBIT decline by 7.0% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Playmates 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. Playmates 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. In the last three years, Playmates Holdings's free cash flow amounted to 44% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing Up

While it is always sensible to investigate a company's debt, in this case Playmates Holdings has HK$880.3m in net cash and a decent-looking balance sheet. So is Playmates 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 instance, we've identified 2 warning signs for Playmates Holdings (1 is concerning) you should be aware of.

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.