Is Essex Bio-Technology (HKG:1061) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

View our latest analysis for Essex Bio-Technology

What Is Essex Bio-Technology's Debt?

As you can see below, at the end of December 2020, Essex Bio-Technology had HK$555.4m of debt, up from HK$360.2m a year ago. Click the image for more detail. However, its balance sheet shows it holds HK$599.8m in cash, so it actually has HK$44.4m net cash.

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

We can see from the most recent balance sheet that Essex Bio-Technology had liabilities of HK$606.0m falling due within a year, and liabilities of HK$389.1m due beyond 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 actually has 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!

It is just as well that Essex Bio-Technology's load is not too heavy, because its EBIT was down 29% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. That limp level of cash conversion undermines its ability to manage and pay down debt.

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$44.4m, as well as more liquid assets than liabilities. 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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Essex Bio-Technology (1 is significant!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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