These 4 Measures Indicate That Colour Life Services Group (HKG:1778) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Colour Life Services Group Co., Limited (HKG:1778) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Colour Life Services Group

What Is Colour Life Services Group's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 Colour Life Services Group had debt of CN¥2.53b, up from CN¥2.30b in one year. However, it does have CN¥2.46b in cash offsetting this, leading to net debt of about CN¥71.0m.

A Look At Colour Life Services Group's Liabilities

The latest balance sheet data shows that Colour Life Services Group had liabilities of CN¥4.95b due within a year, and liabilities of CN¥792.4m falling due after that. On the other hand, it had cash of CN¥2.46b and CN¥1.73b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥1.55b.

While this might seem like a lot, it is not so bad since Colour Life Services Group has a market capitalization of CN¥4.03b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With net debt at just 0.07 times EBITDA, it seems Colour Life Services Group only uses a little bit of leverage. But EBIT was only 4.5 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. Unfortunately, Colour Life Services Group's EBIT flopped 13% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Colour Life Services Group 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. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Colour Life Services Group produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

When it comes to the balance sheet, the standout positive for Colour Life Services Group was the fact that it seems able handle its debt, based on its EBITDA, confidently. However, our other observations weren't so heartening. In particular, EBIT growth rate gives us cold feet. When we consider all the factors mentioned above, we do feel a bit cautious about Colour Life Services Group's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. We've identified 3 warning signs with Colour Life Services Group , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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