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 Chinese People Holdings Company Limited (HKG:681) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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, 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.
How Much Debt Does Chinese People Holdings Carry?
The chart below, which you can click on for greater detail, shows that Chinese People Holdings had CN¥100.3m in debt in December 2021; about the same as the year before. However, it does have CN¥576.6m in cash offsetting this, leading to net cash of CN¥476.3m.
How Strong Is Chinese People Holdings' Balance Sheet?
The latest balance sheet data shows that Chinese People Holdings had liabilities of CN¥586.4m due within a year, and liabilities of CN¥56.1m falling due after that. Offsetting this, it had CN¥576.6m in cash and CN¥158.3m in receivables that were due within 12 months. So it can boast CN¥92.4m more liquid assets than total liabilities.
It's good to see that Chinese People Holdings has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Chinese People Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
In fact Chinese People Holdings's saving grace is its low debt levels, because its EBIT has tanked 27% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Chinese People 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Chinese People Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Happily for any shareholders, Chinese People Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
While it is always sensible to investigate a company's debt, in this case Chinese People Holdings has CN¥476.3m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 102% of that EBIT to free cash flow, bringing in CN¥35m. So we don't think Chinese People Holdings's use of debt is risky. 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. Case in point: We've spotted 1 warning sign for Chinese People Holdings you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.