Hengan International Group (HKG:1044) Seems To Use Debt Rather Sparingly

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Hengan International Group Company Limited (HKG:1044) does use debt in its business. 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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Hengan International Group

What Is Hengan International Group's Net Debt?

The chart below, which you can click on for greater detail, shows that Hengan International Group had CN¥20.8b in debt in December 2020; about the same as the year before. On the flip side, it has CN¥20.6b in cash leading to net debt of about CN¥251.7m.

How Strong Is Hengan International Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Hengan International Group had liabilities of CN¥22.1b due within 12 months and liabilities of CN¥2.72b due beyond that. On the other hand, it had cash of CN¥20.6b and CN¥5.04b worth of receivables due within a year. So it can boast CN¥846.3m more liquid assets than total liabilities.

Having regard to Hengan International Group's size, it seems that its liquid assets are well balanced with its total liabilities. So it's very unlikely that the CN¥53.6b company is short on cash, but still worth keeping an eye on the balance sheet. But either way, Hengan International Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Hengan International Group has very modest net debt levels, with net debt at just 0.035 times EBITDA. Happily, it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt as easily as enthusiastic spray-tanners take on an orange hue. Another good sign is that Hengan International Group has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hengan International Group 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Hengan International Group produced sturdy free cash flow equating to 64% 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.

Our View

The good news is that Hengan International Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Overall, we don't think Hengan International Group is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, 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. Case in point: We've spotted 1 warning sign for Hengan International Group you should be aware of.

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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