Stock Analysis

Does Arts Optical International Holdings (HKG:1120) Have A Healthy Balance Sheet?

SEHK:1120
Source: Shutterstock

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Arts Optical International Holdings Limited (HKG:1120) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Arts Optical International Holdings

What Is Arts Optical International Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Arts Optical International Holdings had debt of HK$41.2m, up from HK$17.0m in one year. But on the other hand it also has HK$145.7m in cash, leading to a HK$104.5m net cash position.

debt-equity-history-analysis
SEHK:1120 Debt to Equity History December 16th 2022

A Look At Arts Optical International Holdings' Liabilities

The latest balance sheet data shows that Arts Optical International Holdings had liabilities of HK$510.4m due within a year, and liabilities of HK$24.5m falling due after that. Offsetting these obligations, it had cash of HK$145.7m as well as receivables valued at HK$324.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$65.1m.

Arts Optical International Holdings has a market capitalization of HK$301.3m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Arts Optical International Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Arts Optical International Holdings turned things around in the last 12 months, delivering and EBIT of HK$51m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Arts 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Arts Optical 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 year, Arts Optical International Holdings burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

Although Arts Optical 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. So we don't have any problem with Arts Optical International Holdings's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Arts Optical International Holdings .

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.

New: Manage All Your Stock Portfolios in One Place

We've created the ultimate portfolio companion for stock investors, and it's free.

• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks

Try a Demo Portfolio for Free

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.