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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Sprocomm Intelligence Limited (HKG:1401) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Sprocomm Intelligence's Debt?
You can click the graphic below for the historical numbers, but it shows that Sprocomm Intelligence had CN¥68.8m of debt in June 2020, down from CN¥120.7m, one year before. However, it does have CN¥193.9m in cash offsetting this, leading to net cash of CN¥125.1m.
How Healthy Is Sprocomm Intelligence's Balance Sheet?
According to the last reported balance sheet, Sprocomm Intelligence had liabilities of CN¥873.2m due within 12 months, and liabilities of CN¥55.5m due beyond 12 months. Offsetting these obligations, it had cash of CN¥193.9m as well as receivables valued at CN¥467.5m due within 12 months. So it has liabilities totalling CN¥267.2m more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Sprocomm Intelligence has a market capitalization of CN¥626.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Sprocomm Intelligence also has more cash than debt, so we're pretty confident it can manage its debt safely. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Sprocomm Intelligence 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, Sprocomm Intelligence made a loss at the EBIT level, and saw its revenue drop to CN¥2.8b, which is a fall of 6.0%. We would much prefer see growth.
So How Risky Is Sprocomm Intelligence?
While Sprocomm Intelligence lost money on an earnings before interest and tax (EBIT) level, it actually booked a paper profit of CN¥38m. So taking that on face value, and considering the cash, we don't think its very risky in the near term. Until we see some positive EBIT, we're a bit cautious of the stock, not least because of the rather modest revenue growth. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 4 warning signs we've spotted with Sprocomm Intelligence (including 2 which is are significant) .
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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