Cosmopolitan International Holdings (HKG:120) Has A Pretty Healthy Balance Sheet

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, Cosmopolitan International Holdings Limited (HKG:120) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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.

See our latest analysis for Cosmopolitan International Holdings

How Much Debt Does Cosmopolitan International Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Cosmopolitan International Holdings had HK$761.8m of debt in December 2021, down from HK$1.05b, one year before. On the flip side, it has HK$138.1m in cash leading to net debt of about HK$623.7m.

How Healthy Is Cosmopolitan International Holdings' Balance Sheet?

We can see from the most recent balance sheet that Cosmopolitan International Holdings had liabilities of HK$2.29b falling due within a year, and liabilities of HK$927.1m due beyond that. On the other hand, it had cash of HK$138.1m and HK$9.90m worth of receivables due within a year. So it has liabilities totalling HK$3.07b more than its cash and near-term receivables, combined.

Cosmopolitan International Holdings has a market capitalization of HK$13.0b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Cosmopolitan International Holdings's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 10.9 times the size. So we're pretty relaxed about its super-conservative use of debt. Although Cosmopolitan International Holdings made a loss at the EBIT level, last year, it was also good to see that it generated HK$553m in EBIT over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Cosmopolitan International Holdings'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Cosmopolitan International Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On our analysis Cosmopolitan International Holdings's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. Looking at all this data makes us feel a little cautious about Cosmopolitan International Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Cosmopolitan International Holdings , and understanding them should be part of your investment process.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.