Here's Why Narnia (Hong Kong) Group (HKG:8607) Can Afford Some Debt

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. We note that Narnia (Hong Kong) Group Company Limited (HKG:8607) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Narnia (Hong Kong) Group

How Much Debt Does Narnia (Hong Kong) Group Carry?

The image below, which you can click on for greater detail, shows that Narnia (Hong Kong) Group had debt of CN¥57.5m at the end of June 2023, a reduction from CN¥91.2m over a year. On the flip side, it has CN¥9.21m in cash leading to net debt of about CN¥48.2m.

How Healthy Is Narnia (Hong Kong) Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Narnia (Hong Kong) Group had liabilities of CN¥91.3m due within 12 months and liabilities of CN¥555.0k due beyond that. On the other hand, it had cash of CN¥9.21m and CN¥51.0m worth of receivables due within a year. So it has liabilities totalling CN¥31.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Narnia (Hong Kong) Group is worth CN¥58.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. 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 Narnia (Hong Kong) Group 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.

Over 12 months, Narnia (Hong Kong) Group made a loss at the EBIT level, and saw its revenue drop to CN¥285m, which is a fall of 14%. We would much prefer see growth.

Caveat Emptor

Not only did Narnia (Hong Kong) Group's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost CN¥2.4m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. However, it doesn't help that it burned through CN¥7.4m of cash over the last year. So suffice it to say we consider the stock very risky. 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. To that end, you should learn about the 4 warning signs we've spotted with Narnia (Hong Kong) Group (including 3 which don't sit too well with us) .

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.