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

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.' 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. Importantly, China Literature Limited (HKG:772) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for China Literature

What Is China Literature's Debt?

You can click the graphic below for the historical numbers, but it shows that China Literature had CN¥594.9m of debt in June 2022, down from CN¥1.22b, one year before. But it also has CN¥7.16b in cash to offset that, meaning it has CN¥6.56b net cash.

A Look At China Literature's Liabilities

Zooming in on the latest balance sheet data, we can see that China Literature had liabilities of CN¥4.31b due within 12 months and liabilities of CN¥830.3m due beyond that. Offsetting these obligations, it had cash of CN¥7.16b as well as receivables valued at CN¥3.26b due within 12 months. So it can boast CN¥5.27b more liquid assets than total liabilities.

It's good to see that China Literature has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, China Literature boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that China Literature's load is not too heavy, because its EBIT was down 36% 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 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. While China Literature has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, China Literature actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing Up

While it is always sensible to investigate a company's debt, in this case China Literature has CN¥6.56b in net cash and a decent-looking balance sheet. The cherry on top was that in converted 111% of that EBIT to free cash flow, bringing in CN¥1.1b. So is China Literature's debt a risk? It doesn't seem so to us. We'd be motivated to research the stock further if we found out that China Literature insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.