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.' 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 Midland Holdings Limited (HKG:1200) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
See our latest analysis for Midland Holdings
What Is Midland Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Midland Holdings had debt of HK$1.18b, up from HK$924.7m in one year. However, it does have HK$1.93b in cash offsetting this, leading to net cash of HK$745.3m.
A Look At Midland Holdings' Liabilities
We can see from the most recent balance sheet that Midland Holdings had liabilities of HK$5.47b falling due within a year, and liabilities of HK$232.3m due beyond that. Offsetting these obligations, it had cash of HK$1.93b as well as receivables valued at HK$4.23b due within 12 months. So it actually has HK$455.9m more liquid assets than total liabilities.
This surplus liquidity suggests that Midland Holdings' balance sheet could take a hit just as well as Homer Simpson's head can take a punch. On this view, lenders should feel as safe as the beloved of a black-belt karate master. Succinctly put, Midland Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
It was also good to see that despite losing money on the EBIT line last year, Midland Holdings turned things around in the last 12 months, delivering and EBIT of HK$268m. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Midland Holdings's ability to maintain a healthy balance sheet going forward. 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. While Midland 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. Over the last year, Midland Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Summing up
While it is always sensible to investigate a company's debt, in this case Midland Holdings has HK$745.3m in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of HK$755m, being 282% of its EBIT. So we don't think Midland Holdings's use of debt is risky. 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. We've identified 3 warning signs with Midland Holdings , and understanding them should be part of your investment process.
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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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.
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About SEHK:1200
Midland Holdings
An investment holding company, provides property agency services in Hong Kong, Macau, and Mainland China.
Undervalued with excellent balance sheet.