We Think China Literature (HKG:772) Can Manage Its Debt With Ease

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 China Literature Limited (HKG:772) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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.

Check out our latest analysis for China Literature

How Much Debt Does China Literature Carry?

As you can see below, China Literature had CN¥1.25b of debt at December 2020, down from CN¥1.30b a year prior. However, its balance sheet shows it holds CN¥6.26b in cash, so it actually has CN¥5.01b net cash.

How Strong Is China Literature's Balance Sheet?

We can see from the most recent balance sheet that China Literature had liabilities of CN¥4.22b falling due within a year, and liabilities of CN¥2.00b due beyond that. Offsetting this, it had CN¥6.26b in cash and CN¥3.61b in receivables that were due within 12 months. So it actually has CN¥3.65b 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. Simply put, the fact that China Literature has more cash than debt is arguably a good indication that it can manage its debt safely.

On top of that, China Literature grew its EBIT by 30% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine China Literature'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. 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 94% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case China Literature has CN¥5.01b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in CN¥822m. So is China Literature's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 1 warning sign for China Literature that you should be aware of before investing here.

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.

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