Is S.A.S. Dragon Holdings (HKG:1184) A Risky Investment?

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.' 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. We note that S.A.S. Dragon Holdings Limited (HKG:1184) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for S.A.S. Dragon Holdings

What Is S.A.S. Dragon Holdings's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 S.A.S. Dragon Holdings had debt of HK$3.22b, up from HK$2.63b in one year. However, it does have HK$1.23b in cash offsetting this, leading to net debt of about HK$1.98b.

How Strong Is S.A.S. Dragon Holdings's Balance Sheet?

We can see from the most recent balance sheet that S.A.S. Dragon Holdings had liabilities of HK$4.65b falling due within a year, and liabilities of HK$348.4m due beyond that. On the other hand, it had cash of HK$1.23b and HK$2.18b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by HK$1.59b.

This deficit is considerable relative to its market capitalization of HK$1.72b, so it does suggest shareholders should keep an eye on S.A.S. Dragon Holdings'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.

S.A.S. Dragon Holdings has a debt to EBITDA ratio of 3.7 and its EBIT covered its interest expense 5.2 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. S.A.S. Dragon Holdings grew its EBIT by 2.1% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is S.A.S. Dragon 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, S.A.S. Dragon Holdings actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

S.A.S. Dragon Holdings's level of total liabilities and net debt to EBITDA 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. We think that S.A.S. Dragon Holdings's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for S.A.S. Dragon Holdings (1 makes us a bit uncomfortable) you should be aware of.

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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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. 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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