Emperor Watch & Jewellery (HKG:887) Has A Somewhat Strained Balance Sheet

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.' 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. We note that Emperor Watch & Jewellery Limited (HKG:887) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Emperor Watch & Jewellery

What Is Emperor Watch & Jewellery's Debt?

You can click the graphic below for the historical numbers, but it shows that Emperor Watch & Jewellery had HK$638.7m of debt in December 2020, down from HK$790.9m, one year before. However, it also had HK$405.1m in cash, and so its net debt is HK$233.6m.

How Healthy Is Emperor Watch & Jewellery's Balance Sheet?

The latest balance sheet data shows that Emperor Watch & Jewellery had liabilities of HK$1.03b due within a year, and liabilities of HK$197.1m falling due after that. On the other hand, it had cash of HK$405.1m and HK$134.0m worth of receivables due within a year. So its liabilities total HK$685.2m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$1.05b, so it does suggest shareholders should keep an eye on Emperor Watch & Jewellery's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Emperor Watch & Jewellery's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that Emperor Watch & Jewellery's EBIT was down 62% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Emperor Watch & Jewellery will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Emperor Watch & Jewellery actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Emperor Watch & Jewellery's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Emperor Watch & Jewellery's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Emperor Watch & Jewellery that you should be aware of.

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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