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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Essex Bio-Technology Limited (HKG:1061) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Essex Bio-Technology

How Much Debt Does Essex Bio-Technology Carry?

The image below, which you can click on for greater detail, shows that at December 2020 Essex Bio-Technology had debt of HK$555.4m, up from HK$360.2m in one year. But on the other hand it also has HK$599.8m in cash, leading to a HK$44.4m net cash position.

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

The latest balance sheet data shows that Essex Bio-Technology had liabilities of HK$606.0m due within a year, and liabilities of HK$389.1m falling due after that. On the other hand, it had cash of HK$599.8m and HK$516.2m worth of receivables due within a year. So it can boast HK$120.8m more liquid assets than total liabilities.

This short term liquidity is a sign that Essex Bio-Technology could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, Essex Bio-Technology boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Essex Bio-Technology if management cannot prevent a repeat of the 29% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Essex Bio-Technology can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Essex Bio-Technology 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. In the last three years, Essex Bio-Technology created free cash flow amounting to 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Essex Bio-Technology has HK$44.4m in net cash and a decent-looking balance sheet. So we are not troubled with Essex Bio-Technology'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. For example, we've discovered 2 warning signs for Essex Bio-Technology (1 doesn't sit too well with us!) 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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