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

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.' 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. 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?

When Is Debt Dangerous?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Elegance Optical International Holdings

What Is Elegance Optical International Holdings's Debt?

As you can see below, at the end of September 2024, Elegance Optical International Holdings had HK$42.9m of debt, up from HK$9.70m a year ago. Click the image for more detail. However, it does have HK$4.02m in cash offsetting this, leading to net debt of about HK$38.9m.

How Strong Is Elegance Optical International Holdings' Balance Sheet?

According to the last reported balance sheet, Elegance Optical International Holdings had liabilities of HK$97.2m due within 12 months, and liabilities of HK$1.13m due beyond 12 months. On the other hand, it had cash of HK$4.02m and HK$6.21m worth of receivables due within a year. So its liabilities total HK$88.1m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of HK$95.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. There's no doubt that we learn most about debt from the balance sheet. But it is Elegance Optical International Holdings's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

In the last year Elegance Optical International Holdings had a loss before interest and tax, and actually shrunk its revenue by 20%, to HK$21m. That makes us nervous, to say the least.

Caveat Emptor

Not only did Elegance Optical International Holdings's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping HK$51m. 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 HK$32m in negative free cash flow over the last twelve months. So suffice it to say we consider the stock very risky. 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. We've identified 4 warning signs with Elegance Optical International Holdings (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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.