Here's Why China Oriented International Holdings (HKG:1871) Can Manage Its Debt Responsibly

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 China Oriented International Holdings Limited (HKG:1871) makes use of debt. But should shareholders be worried about its use of debt?

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. 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.

View our latest analysis for China Oriented International Holdings

What Is China Oriented International Holdings's Debt?

As you can see below, China Oriented International Holdings had CN¥38.8m of debt at June 2020, down from CN¥50.2m a year prior. However, it does have CN¥160.2m in cash offsetting this, leading to net cash of CN¥121.4m.

How Strong Is China Oriented International Holdings's Balance Sheet?

The latest balance sheet data shows that China Oriented International Holdings had liabilities of CN¥92.8m due within a year, and liabilities of CN¥13.4m falling due after that. Offsetting these obligations, it had cash of CN¥160.2m as well as receivables valued at CN¥2.11m due within 12 months. So it actually has CN¥56.1m more liquid assets than total liabilities.

This excess liquidity is a great indication that China Oriented International Holdings's balance sheet is just as strong as racists are weak. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, China Oriented International Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that China Oriented International Holdings's load is not too heavy, because its EBIT was down 56% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is China Oriented 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While China Oriented 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. During the last three years, China Oriented International Holdings produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case China Oriented International Holdings has CN¥121.4m in net cash and a decent-looking balance sheet. So is China Oriented International Holdings's debt a risk? It doesn't seem so to us. 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. To that end, you should learn about the 4 warning signs we've spotted with China Oriented International Holdings (including 2 which is are a bit unpleasant) .

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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This article by Simply Wall St is general in nature. 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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