Here's Why Auto Italia Holdings (HKG:720) Can Afford Some Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. As with many other companies Auto Italia Holdings Limited (HKG:720) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Auto Italia Holdings

What Is Auto Italia Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Auto Italia Holdings had debt of HK$131.8m, up from HK$15.7m in one year. On the flip side, it has HK$48.4m in cash leading to net debt of about HK$83.4m.

How Healthy Is Auto Italia Holdings's Balance Sheet?

The latest balance sheet data shows that Auto Italia Holdings had liabilities of HK$54.2m due within a year, and liabilities of HK$136.5m falling due after that. On the other hand, it had cash of HK$48.4m and HK$33.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$109.3m.

Of course, Auto Italia Holdings has a market capitalization of HK$896.5m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. There's no doubt that we learn most about debt from the balance sheet. But it is Auto Italia 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.

Over 12 months, Auto Italia Holdings made a loss at the EBIT level, and saw its revenue drop to HK$151m, which is a fall of 47%. To be frank that doesn't bode well.

Caveat Emptor

Not only did Auto Italia Holdings's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Indeed, it lost HK$43m at the EBIT level. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. We would feel better if it turned its trailing twelve month loss of HK$43m into a profit. So in short it's a really risky stock. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Auto Italia Holdings .

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. 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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