Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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 China Netcom Technology Holdings Limited (HKG:8071) makes use of debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does China Netcom Technology Holdings Carry?
The image below, which you can click on for greater detail, shows that at June 2019 China Netcom Technology Holdings had debt of HK$15.5m, up from HK$13.0m in one year. However, its balance sheet shows it holds HK$56.1m in cash, so it actually has HK$40.6m net cash.
How Strong Is China Netcom Technology Holdings’s Balance Sheet?
The latest balance sheet data shows that China Netcom Technology Holdings had liabilities of HK$39.1m due within a year, and liabilities of HK$39.3m falling due after that. Offsetting this, it had HK$56.1m in cash and HK$39.4m in receivables that were due within 12 months. So it can boast HK$17.1m more liquid assets than total liabilities.
This surplus suggests that China Netcom Technology Holdings has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, China Netcom Technology Holdings boasts net cash, so it’s fair to say it does not have a heavy debt load!
Better yet, China Netcom Technology Holdings grew its EBIT by 3131% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since China Netcom Technology Holdings 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. While China Netcom Technology 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 two years, China Netcom Technology Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
While it is always sensible to investigate a company’s debt, in this case China Netcom Technology Holdings has HK$40.6m in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 3131% over the last year. So is China Netcom Technology Holdings’s debt a risk? It doesn’t seem so to us. 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. Like risks, for instance. Every company has them, and we’ve spotted 2 warning signs for China Netcom Technology Holdings (of which 1 is a bit unpleasant!) you should know about.
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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