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. As with many other companies Next Digital Limited (HKG:282) makes use of debt. But the more important question is: how much risk is that debt creating?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Next Digital's Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Next Digital had HK$705.9m of debt, an increase on HK$471.6m, over one year. However, it does have HK$190.6m in cash offsetting this, leading to net debt of about HK$515.2m.
A Look At Next Digital's Liabilities
Zooming in on the latest balance sheet data, we can see that Next Digital had liabilities of HK$733.4m due within 12 months and liabilities of HK$757.5m due beyond that. Offsetting these obligations, it had cash of HK$190.6m as well as receivables valued at HK$164.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.14b.
The deficiency here weighs heavily on the HK$622.1m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Next Digital would probably need a major re-capitalization if its creditors were to demand repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Next Digital'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.
Over 12 months, Next Digital made a loss at the EBIT level, and saw its revenue drop to HK$1.2b, which is a fall of 2.3%. That's not what we would hope to see.
Importantly, Next Digital had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable HK$349m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of HK$222m over the last twelve months. So suffice it to say we consider the stock to be risky. 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. For instance, we've identified 3 warning signs for Next Digital (2 make us uncomfortable) you should be aware of.
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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