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. Importantly, China Public Procurement Limited (HKG:1094) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
How Much Debt Does China Public Procurement Carry?
The image below, which you can click on for greater detail, shows that China Public Procurement had debt of HK$30.9m at the end of December 2020, a reduction from HK$33.5m over a year. However, it does have HK$17.7m in cash offsetting this, leading to net debt of about HK$13.2m.
How Strong Is China Public Procurement's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that China Public Procurement had liabilities of HK$76.7m due within 12 months and liabilities of HK$78.8m due beyond that. On the other hand, it had cash of HK$17.7m and HK$18.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$119.7m.
The deficiency here weighs heavily on the HK$51.3m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, China Public Procurement would likely require a major re-capitalisation if it had to pay its creditors today. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since China Public Procurement 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.
Over 12 months, China Public Procurement reported revenue of HK$94m, which is a gain of 28%, although it did not report any earnings before interest and tax. With any luck the company will be able to grow its way to profitability.
Despite the top line growth, China Public Procurement still had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost a very considerable HK$8.7m at the EBIT level. Considering that alongside the liabilities mentioned above make us nervous about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. On the bright side, we note that trailing twelve month EBIT is worse than the free cash flow of HK$1.2m and the profit of HK$1.6m. So one might argue that there's still a chance it can get things on the right track. 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. For instance, we've identified 3 warning signs for China Public Procurement (1 can't be ignored) 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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