Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies China Literature Limited (HKG:772) makes use of debt. But should shareholders be worried about its use of debt?
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. 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.
What Is China Literature's Net Debt?
The image below, which you can click on for greater detail, shows that China Literature had debt of CN¥1.22b at the end of June 2021, a reduction from CN¥1.86b over a year. However, it does have CN¥6.91b in cash offsetting this, leading to net cash of CN¥5.69b.
A Look At China Literature's Liabilities
The latest balance sheet data shows that China Literature had liabilities of CN¥4.52b due within a year, and liabilities of CN¥1.71b falling due after that. On the other hand, it had cash of CN¥6.91b and CN¥3.36b worth of receivables due within a year. So it actually has CN¥4.04b more liquid assets than total liabilities.
This surplus suggests that China Literature has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, China Literature boasts net cash, so it's fair to say it does not have a heavy debt load!
In addition to that, we're happy to report that China Literature has boosted its EBIT by 76%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if China Literature 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. China Literature may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, China Literature generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
While we empathize with investors who find debt concerning, you should keep in mind that China Literature has net cash of CN¥5.69b, as well as more liquid assets than liabilities. And it impressed us with free cash flow of CN¥718m, being 92% of its EBIT. So we don't think China Literature's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. 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 2 warning signs for China Literature 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.
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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.
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