Is E-Commodities Holdings (HKG:1733) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that E-Commodities Holdings Limited (HKG:1733) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for E-Commodities Holdings

What Is E-Commodities Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that E-Commodities Holdings had HK$1.72b of debt in December 2020, down from HK$3.73b, one year before. However, it does have HK$1.63b in cash offsetting this, leading to net debt of about HK$82.5m.

A Look At E-Commodities Holdings' Liabilities

According to the last reported balance sheet, E-Commodities Holdings had liabilities of HK$4.48b due within 12 months, and liabilities of HK$399.0m due beyond 12 months. On the other hand, it had cash of HK$1.63b and HK$1.72b worth of receivables due within a year. So its liabilities total HK$1.53b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's HK$1.33b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 0.10 and interest cover of 4.9 times, it seems to us that E-Commodities Holdings is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that E-Commodities Holdings's EBIT shot up like bamboo after rain, gaining 45% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since E-Commodities 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. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, E-Commodities Holdings actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, E-Commodities Holdings's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its level of total liabilities has the opposite effect. All these things considered, it appears that E-Commodities Holdings can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with E-Commodities Holdings .

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. 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.
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