Is Digital Domain Holdings (HKG:547) A Risky Investment?

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.' 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.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Digital Domain Holdings

What Is Digital Domain Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Digital Domain Holdings had HK$280.0m of debt in June 2021, down from HK$308.9m, one year before. But on the other hand it also has HK$349.1m in cash, leading to a HK$69.1m net cash position.

How Healthy Is Digital Domain Holdings' Balance Sheet?

We can see from the most recent balance sheet that Digital Domain Holdings had liabilities of HK$349.6m falling due within a year, and liabilities of HK$329.1m due beyond that. Offsetting these obligations, it had cash of HK$349.1m as well as receivables valued at HK$162.6m due within 12 months. So it has liabilities totalling HK$167.0m more than its cash and near-term receivables, combined.

Given Digital Domain Holdings has a market capitalization of HK$3.29b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Digital Domain Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely. When analysing debt levels, the balance sheet is the obvious place to start. 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$684m, which is a gain of 15%, although it did not report any earnings before interest and tax. That rate of growth is a bit slow for our taste, but it takes all types to make a world.

So How Risky Is Digital Domain Holdings?

By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that Digital Domain Holdings had an earnings before interest and tax (EBIT) loss, over the last year. Indeed, in that time it burnt through HK$193m of cash and made a loss of HK$581m. But at least it has HK$69.1m on the balance sheet to spend on growth, near-term. Overall, we'd say the stock is a bit risky, and we're usually very cautious until we see positive free cash flow. 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. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Digital Domain Holdings (of which 1 is a bit unpleasant!) you should know about.

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.

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.

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