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.' 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. As with many other companies Come Sure Group (Holdings) Limited (HKG:794) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Come Sure Group (Holdings)'s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Come Sure Group (Holdings) had HK$297.5m of debt in March 2020, down from HK$396.7m, one year before. On the flip side, it has HK$210.4m in cash leading to net debt of about HK$87.2m.
A Look At Come Sure Group (Holdings)'s Liabilities
We can see from the most recent balance sheet that Come Sure Group (Holdings) had liabilities of HK$476.8m falling due within a year, and liabilities of HK$86.0m due beyond that. Offsetting these obligations, it had cash of HK$210.4m as well as receivables valued at HK$235.0m due within 12 months. So it has liabilities totalling HK$117.4m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Come Sure Group (Holdings) has a market capitalization of HK$212.1m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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 1.2 and interest cover of 3.5 times, it seems to us that Come Sure Group (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. Sadly, Come Sure Group (Holdings)'s EBIT actually dropped 3.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Come Sure Group (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. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Come Sure Group (Holdings) recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Come Sure Group (Holdings)'s conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its interest cover makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Come Sure Group (Holdings)'s debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 5 warning signs with Come Sure Group (Holdings) (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
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.
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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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