Migao Group Holdings (HKG:9879) Seems To Use Debt Quite Sensibly

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Migao Group Holdings Limited (HKG:9879) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Migao Group Holdings

What Is Migao Group Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that Migao Group Holdings had debt of CN¥385.4m at the end of September 2024, a reduction from CN¥545.2m over a year. But on the other hand it also has CN¥458.9m in cash, leading to a CN¥73.5m net cash position.

A Look At Migao Group Holdings' Liabilities

According to the last reported balance sheet, Migao Group Holdings had liabilities of CN¥1.49b due within 12 months, and liabilities of CN¥151.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥458.9m as well as receivables valued at CN¥2.55b due within 12 months. So it actually has CN¥1.37b more liquid assets than total liabilities.

This excess liquidity suggests that Migao Group Holdings is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Simply put, the fact that Migao Group Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.

In fact Migao Group Holdings's saving grace is its low debt levels, because its EBIT has tanked 21% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But it is Migao Group Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Migao Group 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. Over the last three years, Migao Group Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Migao Group Holdings has net cash of CN¥73.5m, as well as more liquid assets than liabilities. So we don't have any problem with Migao Group Holdings's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Migao Group Holdings you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.