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, Nanfang Communication Holdings Limited (HKG:1617) does carry debt. But is this debt a concern to shareholders?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.
What Is Nanfang Communication Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at December 2020 Nanfang Communication Holdings had debt of CN¥295.2m, up from CN¥244.0m in one year. However, it also had CN¥207.2m in cash, and so its net debt is CN¥88.0m.
A Look At Nanfang Communication Holdings' Liabilities
The latest balance sheet data shows that Nanfang Communication Holdings had liabilities of CN¥495.6m due within a year, and liabilities of CN¥20.7m falling due after that. Offsetting this, it had CN¥207.2m in cash and CN¥398.8m in receivables that were due within 12 months. So it can boast CN¥89.7m more liquid assets than total liabilities.
This surplus suggests that Nanfang Communication Holdings is using debt in a way that is appears to be both safe and conservative. Due to its strong net asset position, it is not likely to face issues with its lenders. 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 Nanfang Communication 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.
In the last year Nanfang Communication Holdings had a loss before interest and tax, and actually shrunk its revenue by 29%, to CN¥380m. To be frank that doesn't bode well.
While Nanfang Communication Holdings's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost a very considerable CN¥43m at the EBIT level. On a more positive note, the company does have liquid assets, so it has a bit of time to improve its operations before the debt becomes an acute problem. Still, we'd be more encouraged to study the business in depth if it already had some free cash flow. This one is a bit too risky for our liking. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Nanfang Communication Holdings you should be aware of, and 1 of them is concerning.
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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