We Think CEC International Holdings (HKG:759) Is Taking Some Risk With Its 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.' 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. We note that CEC International Holdings Limited (HKG:759) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 CEC International Holdings

What Is CEC International Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of October 2023 CEC International Holdings had HK$13.6m of debt, an increase on HK$12.9m, over one year. But on the other hand it also has HK$118.1m in cash, leading to a HK$104.5m net cash position.

How Healthy Is CEC International Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CEC International Holdings had liabilities of HK$285.8m due within 12 months and liabilities of HK$118.3m due beyond that. Offsetting this, it had HK$118.1m in cash and HK$10.6m in receivables that were due within 12 months. So its liabilities total HK$275.4m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the HK$163.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, CEC International Holdings would probably need a major re-capitalization if its creditors were to demand repayment. CEC International Holdings boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Importantly, CEC International Holdings's EBIT fell a jaw-dropping 48% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is CEC International Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While CEC International Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, CEC International Holdings actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

Although CEC International Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of HK$104.5m. And it impressed us with free cash flow of HK$167m, being 550% of its EBIT. Despite its cash we think that CEC International Holdings seems to struggle to handle its total liabilities, so we are wary of the stock. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for CEC International Holdings you should know about.

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.