These 4 Measures Indicate That Art Group Holdings (HKG:565) Is Using Debt Extensively

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 can see that Art Group Holdings Limited (HKG:565) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Art Group Holdings

How Much Debt Does Art Group Holdings Carry?

As you can see below, Art Group Holdings had HK$25.3m of debt at June 2022, down from HK$34.4m a year prior. However, it does have HK$21.5m in cash offsetting this, leading to net debt of about HK$3.82m.

How Strong Is Art Group Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Art Group Holdings had liabilities of HK$207.8m due within 12 months and liabilities of HK$1.08b due beyond that. On the other hand, it had cash of HK$21.5m and HK$235.5m worth of receivables due within a year. So its liabilities total HK$1.03b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the HK$658.8m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Art Group Holdings would likely require a major re-capitalisation if it had to pay its creditors today. Art Group Holdings has a very little net debt but plenty of other liabilities weighing it down.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Art Group Holdings's net debt to EBITDA ratio is very low, at 0.031, suggesting the debt is only trivial. But EBIT was only 6.0 times the interest expense last year, so the borrowing is clearly weighing on the business somewhat. Importantly, Art Group Holdings grew its EBIT by 65% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Art Group Holdings will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Art Group Holdings created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

While Art Group Holdings's level of total liabilities has us nervous. For example, its EBIT growth rate and net debt to EBITDA give us some confidence in its ability to manage its debt. When we consider all the factors discussed, it seems to us that Art Group Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 2 warning signs we've spotted with Art Group Holdings (including 1 which is potentially serious) .

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.