Is Tree Holdings (HKG:8395) A Risky Investment?

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.' 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. As with many other companies Tree Holdings Limited (HKG:8395) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Tree Holdings

What Is Tree Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that Tree Holdings had HK$22.6m of debt in March 2021, down from HK$25.9m, one year before. But it also has HK$37.5m in cash to offset that, meaning it has HK$14.9m net cash.

A Look At Tree Holdings' Liabilities

We can see from the most recent balance sheet that Tree Holdings had liabilities of HK$58.9m falling due within a year, and liabilities of HK$9.01m due beyond that. Offsetting this, it had HK$37.5m in cash and HK$42.6m in receivables that were due within 12 months. So it can boast HK$12.3m more liquid assets than total liabilities.

This state of affairs indicates that Tree Holdings' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the HK$966.2m company is struggling for cash, we still think it's worth monitoring its balance sheet. Succinctly put, Tree Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

In addition to that, we're happy to report that Tree Holdings has boosted its EBIT by 68%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tree Holdings's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Tree 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 three years, Tree Holdings actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

While we empathize with investors who find debt concerning, you should keep in mind that Tree Holdings has net cash of HK$14.9m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of HK$35m, being 111% of its EBIT. So we don't think Tree 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 2 warning signs with Tree 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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