Maoyan Entertainment (HKG:1896) 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 Maoyan Entertainment (HKG:1896) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Maoyan Entertainment

What Is Maoyan Entertainment's Net Debt?

The image below, which you can click on for greater detail, shows that Maoyan Entertainment had debt of CN¥335.0m at the end of December 2022, a reduction from CN¥597.0m over a year. But it also has CN¥2.28b in cash to offset that, meaning it has CN¥1.94b net cash.

How Strong Is Maoyan Entertainment's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Maoyan Entertainment had liabilities of CN¥1.95b due within 12 months and liabilities of CN¥134.9m due beyond that. On the other hand, it had cash of CN¥2.28b and CN¥538.1m worth of receivables due within a year. So it actually has CN¥732.5m more liquid assets than total liabilities.

This surplus suggests that Maoyan Entertainment has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Maoyan Entertainment boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Maoyan Entertainment if management cannot prevent a repeat of the 71% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Maoyan Entertainment can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Maoyan Entertainment 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 most recent two years, Maoyan Entertainment recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While we empathize with investors who find debt concerning, you should keep in mind that Maoyan Entertainment has net cash of CN¥1.94b, as well as more liquid assets than liabilities. So we don't have any problem with Maoyan Entertainment's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Maoyan Entertainment .

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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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.