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.' 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 Champion Alliance International Holdings Limited (HKG:1629) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Champion Alliance International Holdings's Debt?
As you can see below, Champion Alliance International Holdings had CN¥41.8m of debt at June 2021, down from CN¥51.5m a year prior. However, it does have CN¥157.4m in cash offsetting this, leading to net cash of CN¥115.6m.
How Healthy Is Champion Alliance International Holdings' Balance Sheet?
According to the last reported balance sheet, Champion Alliance International Holdings had liabilities of CN¥278.7m due within 12 months, and liabilities of CN¥725.0k due beyond 12 months. Offsetting these obligations, it had cash of CN¥157.4m as well as receivables valued at CN¥99.8m due within 12 months. So it has liabilities totalling CN¥22.2m more than its cash and near-term receivables, combined.
Since publicly traded Champion Alliance International Holdings shares are worth a total of CN¥926.1m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Champion Alliance International Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
Sadly, Champion Alliance International Holdings's EBIT actually dropped 3.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Champion Alliance International Holdings will need earnings to service that debt. 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 Champion Alliance 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, Champion Alliance International Holdings generated free cash flow amounting to a very robust 97% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
We could understand if investors are concerned about Champion Alliance International Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥115.6m. The cherry on top was that in converted 97% of that EBIT to free cash flow, bringing in CN¥73m. So we are not troubled with Champion Alliance International Holdings's debt use. 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 be aware of the 1 warning sign we've spotted with Champion Alliance International Holdings .
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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