Here's Why Perfectech International Holdings (HKG:765) Has A Meaningful Debt Burden

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Perfectech International Holdings Limited (HKG:765) does carry debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 Perfectech International Holdings

What Is Perfectech International Holdings's Debt?

As you can see below, at the end of June 2020, Perfectech International Holdings had HK$53.5m of debt, up from HK$31.8m a year ago. Click the image for more detail. But it also has HK$65.7m in cash to offset that, meaning it has HK$12.2m net cash.

How Healthy Is Perfectech International Holdings's Balance Sheet?

According to the last reported balance sheet, Perfectech International Holdings had liabilities of HK$82.5m due within 12 months, and liabilities of HK$12.8m due beyond 12 months. Offsetting these obligations, it had cash of HK$65.7m as well as receivables valued at HK$20.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$8.85m.

Given Perfectech International Holdings has a market capitalization of HK$116.1m, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Perfectech International Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

We also note that Perfectech International Holdings improved its EBIT from a last year's loss to a positive HK$1.8m. When analysing debt levels, the balance sheet is the obvious place to start. But it is Perfectech International Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Perfectech International 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. During the last year, Perfectech International Holdings burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

We could understand if investors are concerned about Perfectech International Holdings's liabilities, but we can be reassured by the fact it has has net cash of HK$12.2m. So although we see some areas for improvement, we're not too worried about Perfectech International Holdings's balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Perfectech International Holdings (of which 1 makes us a bit uncomfortable!) 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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