Is Elegance Optical International Holdings (HKG:907) Using Debt In A Risky Way?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Elegance Optical International Holdings Limited (HKG:907) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Elegance Optical International Holdings

How Much Debt Does Elegance Optical International Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Elegance Optical International Holdings had HK$23.4m of debt in March 2021, down from HK$38.8m, one year before. But on the other hand it also has HK$122.0m in cash, leading to a HK$98.6m net cash position.

A Look At Elegance Optical International Holdings' Liabilities

We can see from the most recent balance sheet that Elegance Optical International Holdings had liabilities of HK$107.0m falling due within a year, and liabilities of HK$21.0m due beyond that. On the other hand, it had cash of HK$122.0m and HK$49.4m worth of receivables due within a year. So it can boast HK$43.4m more liquid assets than total liabilities.

This short term liquidity is a sign that Elegance Optical International Holdings could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, 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$54m, which is a fall of 19%. We would much prefer see growth.

So How Risky Is Elegance Optical International Holdings?

Statistically speaking companies that lose money are riskier than those that make money. And in the last year Elegance Optical International Holdings had an earnings before interest and tax (EBIT) loss, truth be told. And over the same period it saw negative free cash outflow of HK$46m and booked a HK$15m accounting loss. With only HK$98.6m on the balance sheet, it would appear that its going to need to raise capital again soon. Even though its balance sheet seems sufficiently liquid, debt always makes us a little nervous if a company doesn't produce free cash flow regularly. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Elegance Optical International Holdings (1 is concerning!) that you should be aware of before investing here.

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.
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