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

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. We can see that Narnia (Hong Kong) Group Company Limited (HKG:8607) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Narnia (Hong Kong) Group

What Is Narnia (Hong Kong) Group's Debt?

You can click the graphic below for the historical numbers, but it shows that Narnia (Hong Kong) Group had CN¥57.5m of debt in June 2023, down from CN¥82.9m, one year before. However, it also had CN¥9.21m in cash, and so its net debt is 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. Offsetting this, it had CN¥9.21m in cash and CN¥51.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥31.6m.

This is a mountain of leverage relative to its market capitalization of CN¥45.4m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. 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¥228m, which is a fall of 36%. That makes us nervous, to say the least.

Caveat Emptor

While Narnia (Hong Kong) Group's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at CN¥3.1m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled CN¥7.4m in negative free cash flow over the last twelve months. So in short it's a really risky stock. 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. We've identified 3 warning signs with Narnia (Hong Kong) Group (at least 2 which don't sit too well with us) , and understanding them should be part of your investment process.

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. 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.