Essex Bio-Technology (HKG:1061) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Essex Bio-Technology Limited (HKG:1061) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Essex Bio-Technology

What Is Essex Bio-Technology's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Essex Bio-Technology had debt of HK$353.6m, up from HK$232.2m in one year. But on the other hand it also has HK$392.3m in cash, leading to a HK$38.8m net cash position.

How Healthy Is Essex Bio-Technology's Balance Sheet?

According to the last reported balance sheet, Essex Bio-Technology had liabilities of HK$518.8m due within 12 months, and liabilities of HK$167.5m due beyond 12 months. Offsetting these obligations, it had cash of HK$392.3m as well as receivables valued at HK$515.7m due within 12 months. So it can boast HK$221.7m more liquid assets than total liabilities.

This surplus suggests that Essex Bio-Technology has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Essex Bio-Technology has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Essex Bio-Technology has seen its EBIT plunge 15% in the last twelve months. If that rate of decline in earnings continues, the company could find itself in a tight spot. There's no doubt that we learn most about debt from the balance sheet. But it is Essex Bio-Technology's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Essex Bio-Technology 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. In the last three years, Essex Bio-Technology's free cash flow amounted to 26% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Essex Bio-Technology has net cash of HK$38.8m, as well as more liquid assets than liabilities. So we don't have any problem with Essex Bio-Technology's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Essex Bio-Technology .

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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