Here's Why Values Cultural Investment (HKG:1740) Can Manage Its Debt Responsibly

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. As with many other companies Values Cultural Investment Limited (HKG:1740) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Values Cultural Investment

How Much Debt Does Values Cultural Investment Carry?

As you can see below, Values Cultural Investment had CN¥12.9m of debt at June 2020, down from CN¥32.0m a year prior. However, its balance sheet shows it holds CN¥116.1m in cash, so it actually has CN¥103.1m net cash.

How Healthy Is Values Cultural Investment's Balance Sheet?

The latest balance sheet data shows that Values Cultural Investment had liabilities of CN¥39.6m due within a year, and liabilities of CN¥1.36m falling due after that. On the other hand, it had cash of CN¥116.1m and CN¥115.1m worth of receivables due within a year. So it can boast CN¥190.2m more liquid assets than total liabilities.

This luscious liquidity implies that Values Cultural Investment's balance sheet is sturdy like a giant sequoia tree. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Simply put, the fact that Values Cultural Investment has more cash than debt is arguably a good indication that it can manage its debt safely.

Shareholders should be aware that Values Cultural Investment's EBIT was down 81% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is Values Cultural Investment'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Values Cultural Investment may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Values Cultural Investment 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, the bottom line is that Values Cultural Investment has net cash of CN¥103.1m and plenty of liquid assets. So we are not troubled with Values Cultural Investment's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Like risks, for instance. Every company has them, and we've spotted 4 warning signs for Values Cultural Investment (of which 1 is potentially serious!) you should know about.

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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