We Think China Literature (HKG:772) Can Stay On Top Of Its Debt

June 01, 2022
Source: Shutterstock

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies China Literature Limited (HKG:772) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. 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. 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?

The image below, which you can click on for greater detail, shows that China Literature had debt of CN¥1.18b at the end of December 2021, a reduction from CN¥1.25b over a year. But it also has CN¥7.21b in cash to offset that, meaning it has CN¥6.03b net cash.

SEHK:772 Debt to Equity History June 1st 2022

A Look At China Literature's Liabilities

We can see from the most recent balance sheet that China Literature had liabilities of CN¥4.51b falling due within a year, and liabilities of CN¥1.60b due beyond that. Offsetting these obligations, it had cash of CN¥7.21b as well as receivables valued at CN¥3.33b due within 12 months. So it can boast CN¥4.43b more liquid assets than total liabilities.

This short term liquidity is a sign that China Literature could probably pay off its debt with ease, as its balance sheet is far from stretched. Simply put, the fact that China Literature has more cash than debt is arguably a good indication that it can manage its debt safely.

The modesty of its debt load may become crucial for China Literature if management cannot prevent a repeat of the 34% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that China Literature has net cash of CN¥6.03b, as well as more liquid assets than liabilities. The cherry on top was that in converted 95% of that EBIT to free cash flow, bringing in CN¥1.0b. So we are not troubled with China Literature's debt use. 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. Case in point: We've spotted 2 warning signs for China Literature you should be aware of.

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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About SEHK:772

China Literature

China Literature Limited, an investment holding company, operates an online literature platform in the People’s Republic of China.

Flawless balance sheet and fair value.