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.' 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 can see that China Isotope & Radiation Corporation (HKG:1763) does use debt in its business. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does China Isotope & Radiation Carry?
You can click the graphic below for the historical numbers, but it shows that China Isotope & Radiation had CN¥662.8m of debt in December 2020, down from CN¥788.1m, one year before. However, its balance sheet shows it holds CN¥2.56b in cash, so it actually has CN¥1.89b net cash.
How Strong Is China Isotope & Radiation's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Isotope & Radiation had liabilities of CN¥2.77b due within 12 months and liabilities of CN¥907.5m due beyond that. Offsetting these obligations, it had cash of CN¥2.56b as well as receivables valued at CN¥2.37b due within 12 months. So it can boast CN¥1.25b more liquid assets than total liabilities.
This excess liquidity suggests that China Isotope & Radiation is taking a careful approach to debt. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that China Isotope & Radiation has more cash than debt is arguably a good indication that it can manage its debt safely.
But the bad news is that China Isotope & Radiation has seen its EBIT plunge 13% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if China Isotope & Radiation can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. China Isotope & Radiation 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. Considering the last three years, China Isotope & Radiation actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While we empathize with investors who find debt concerning, you should keep in mind that China Isotope & Radiation has net cash of CN¥1.89b, as well as more liquid assets than liabilities. So we don't have any problem with China Isotope & Radiation's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for China Isotope & Radiation that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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