Here's Why Litian Pictures Holdings (HKG:9958) Can Manage Its Debt Responsibly

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. Importantly, Litian Pictures Holdings Limited (HKG:9958) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Litian Pictures Holdings

What Is Litian Pictures Holdings's Net Debt?

As you can see below, at the end of December 2020, Litian Pictures Holdings had CN¥79.2m of debt, up from CN¥56.7m a year ago. Click the image for more detail. However, it does have CN¥185.7m in cash offsetting this, leading to net cash of CN¥106.5m.

A Look At Litian Pictures Holdings' Liabilities

According to the last reported balance sheet, Litian Pictures Holdings had liabilities of CN¥613.0m due within 12 months, and liabilities of CN¥3.32m due beyond 12 months. On the other hand, it had cash of CN¥185.7m and CN¥474.9m worth of receivables due within a year. So it can boast CN¥44.3m more liquid assets than total liabilities.

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

On the other hand, Litian Pictures Holdings saw its EBIT drop by 5.4% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There's no doubt that we learn most about debt from the balance sheet. But it is Litian Pictures Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Litian Pictures Holdings 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. Looking at the most recent three years, Litian Pictures Holdings recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Litian Pictures Holdings has CN¥106.5m in net cash and a decent-looking balance sheet. So we are not troubled with Litian Pictures Holdings's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Litian Pictures Holdings that you should be aware of before investing here.

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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