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. We can see that Tian Ge Interactive Holdings Limited (HKG:1980) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Tian Ge Interactive Holdings's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Tian Ge Interactive Holdings had debt of CN¥141.4m, up from none in one year. But on the other hand it also has CN¥1.93b in cash, leading to a CN¥1.79b net cash position.
A Look At Tian Ge Interactive Holdings' Liabilities
Zooming in on the latest balance sheet data, we can see that Tian Ge Interactive Holdings had liabilities of CN¥592.0m due within 12 months and liabilities of CN¥41.1m due beyond that. Offsetting this, it had CN¥1.93b in cash and CN¥6.01m in receivables that were due within 12 months. So it actually has CN¥1.31b more liquid assets than total liabilities.
This luscious liquidity implies that Tian Ge Interactive Holdings' balance sheet is sturdy like a giant sequoia tree. Having regard to this fact, we think its balance sheet is as strong as an ox. Simply put, the fact that Tian Ge Interactive Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
It is just as well that Tian Ge Interactive Holdings's load is not too heavy, because its EBIT was down 72% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Tian Ge Interactive Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Tian Ge Interactive 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. During the last three years, Tian Ge Interactive Holdings produced sturdy free cash flow equating to 62% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to investigate a company's debt, in this case Tian Ge Interactive Holdings has CN¥1.79b in net cash and a decent-looking balance sheet. So is Tian Ge Interactive Holdings's debt a risk? It doesn't seem so to us. 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. Be aware that Tian Ge Interactive Holdings is showing 3 warning signs in our investment analysis , and 1 of those is potentially serious...
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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