Is Elegance Optical International Holdings (HKG:907) Using Debt Sensibly?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Elegance Optical International Holdings Limited (HKG:907) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Elegance Optical International Holdings

What Is Elegance Optical International Holdings's Net Debt?

As you can see below, Elegance Optical International Holdings had HK$28.9m of debt at September 2020, down from HK$37.0m a year prior. However, its balance sheet shows it holds HK$84.5m in cash, so it actually has HK$55.7m net cash.

How Healthy Is Elegance Optical International Holdings's Balance Sheet?

The latest balance sheet data shows that Elegance Optical International Holdings had liabilities of HK$117.0m due within a year, and liabilities of HK$28.3m falling due after that. On the other hand, it had cash of HK$84.5m and HK$44.7m worth of receivables due within a year. So it has liabilities totalling HK$16.1m more than its cash and near-term receivables, combined.

Given Elegance Optical International Holdings has a market capitalization of HK$240.2m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Elegance Optical International Holdings boasts net cash, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Elegance Optical International 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.

Over 12 months, Elegance Optical International Holdings made a loss at the EBIT level, and saw its revenue drop to HK$64m, which is a fall of 40%. That makes us nervous, to say the least.

So How Risky Is Elegance Optical International Holdings?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And in the last year Elegance Optical International Holdings had an earnings before interest and tax (EBIT) loss, truth be told. Indeed, in that time it burnt through HK$37m of cash and made a loss of HK$81m. With only HK$55.7m on the balance sheet, it would appear that its going to need to raise capital again soon. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. 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. Case in point: We've spotted 4 warning signs for Elegance Optical International Holdings you should be aware of, and 2 of them shouldn't be ignored.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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