Is Hengxin Technology (HKG:1085) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Hengxin Technology Ltd. (HKG:1085) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Hengxin Technology

What Is Hengxin Technology's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Hengxin Technology had CN¥327.8m of debt, an increase on CN¥315.0m, over one year. However, it does have CN¥1.06b in cash offsetting this, leading to net cash of CN¥729.1m.

How Strong Is Hengxin Technology's Balance Sheet?

According to the last reported balance sheet, Hengxin Technology had liabilities of CN¥534.5m due within 12 months, and liabilities of CN¥14.3m due beyond 12 months. Offsetting these obligations, it had cash of CN¥1.06b as well as receivables valued at CN¥865.8m due within 12 months. So it can boast CN¥1.37b more liquid assets than total liabilities.

This excess liquidity is a great indication that Hengxin Technology's balance sheet is just as strong as racists are weak. Having regard to this fact, we think its balance sheet is just as strong as misogynists are weak. Succinctly put, Hengxin Technology boasts net cash, so it's fair to say it does not have a heavy debt load!

It is just as well that Hengxin Technology's load is not too heavy, because its EBIT was down 56% over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Hengxin Technology 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Hengxin Technology 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, Hengxin Technology 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, the bottom line is that Hengxin Technology has net cash of CN¥729.1m and plenty of liquid assets. The cherry on top was that in converted 120% of that EBIT to free cash flow, bringing in CN¥239m. So we don't think Hengxin Technology'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. For example, we've discovered 2 warning signs for Hengxin Technology (1 is concerning!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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