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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Digital Domain Holdings Limited (HKG:547) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Digital Domain Holdings Carry?
As you can see below, Digital Domain Holdings had HK$288.4m of debt, at December 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has HK$253.1m in cash leading to net debt of about HK$35.3m.
How Healthy Is Digital Domain Holdings' Balance Sheet?
The latest balance sheet data shows that Digital Domain Holdings had liabilities of HK$341.4m due within a year, and liabilities of HK$347.9m falling due after that. Offsetting this, it had HK$253.1m in cash and HK$138.9m in receivables that were due within 12 months. So its liabilities total HK$297.3m more than the combination of its cash and short-term receivables.
Since publicly traded Digital Domain Holdings shares are worth a total of HK$2.55b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, Digital Domain Holdings has virtually no net debt, so it's fair to say it does not have a heavy debt load! There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Digital Domain Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Over 12 months, Digital Domain Holdings reported revenue of HK$864m, which is a gain of 44%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.
Despite the top line growth, Digital Domain Holdings still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost HK$239m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. For example, we would not want to see a repeat of last year's loss of HK$722m. So we do think this stock is quite risky. 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. We've identified 3 warning signs with Digital Domain Holdings (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.
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.
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.