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 Modern Living Investments Holdings Limited (HKG:8426) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.
How Much Debt Does Modern Living Investments Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that Modern Living Investments Holdings had HK$32.8m of debt in June 2019, down from HK$41.7m, one year before. However, it does have HK$55.8m in cash offsetting this, leading to net cash of HK$22.9m.
How Healthy Is Modern Living Investments Holdings’s Balance Sheet?
According to the last reported balance sheet, Modern Living Investments Holdings had liabilities of HK$75.4m due within 12 months, and liabilities of HK$1.42m due beyond 12 months. Offsetting this, it had HK$55.8m in cash and HK$93.6m in receivables that were due within 12 months. So it actually has HK$72.6m more liquid assets than total liabilities.
This luscious liquidity implies that Modern Living Investments Holdings’s balance sheet is sturdy like a giant sequoia tree. On this basis we think its balance sheet is strong like a sleek panther or even a proud lion. Succinctly put, Modern Living Investments Holdings boasts net cash, so it’s fair to say it does not have a heavy debt load!
In fact Modern Living Investments Holdings’s saving grace is its low debt levels, because its EBIT has tanked 39% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Modern Living Investments 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. Modern Living Investments Holdings 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. Over the last three years, Modern Living Investments Holdings recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
While it is always sensible to investigate a company’s debt, in this case Modern Living Investments Holdings has HK$22.9m in net cash and a decent-looking balance sheet. So we are not troubled with Modern Living Investments Holdings’s debt use. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Modern Living Investments Holdings insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.