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Does Putian Communication Group (HKG:1720) Have A Healthy Balance Sheet?
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. As with many other companies Putian Communication Group Limited (HKG:1720) makes use of debt. But the real question is whether this debt is making the company risky.
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Putian Communication Group
What Is Putian Communication Group's Debt?
The image below, which you can click on for greater detail, shows that at December 2021 Putian Communication Group had debt of CN¥259.5m, up from CN¥212.4m in one year. However, it also had CN¥155.4m in cash, and so its net debt is CN¥104.1m.
How Strong Is Putian Communication Group's Balance Sheet?
We can see from the most recent balance sheet that Putian Communication Group had liabilities of CN¥354.0m falling due within a year, and liabilities of CN¥110.3m due beyond that. Offsetting these obligations, it had cash of CN¥155.4m as well as receivables valued at CN¥274.4m due within 12 months. So its liabilities total CN¥34.5m more than the combination of its cash and short-term receivables.
Of course, Putian Communication Group has a market capitalization of CN¥259.0m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Putian Communication Group has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 22.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Putian Communication Group grew its EBIT by 33% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Putian Communication Group'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Putian Communication Group saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Happily, Putian Communication Group's impressive interest cover implies it has the upper hand on its debt. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Putian Communication Group can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Putian Communication Group (of which 1 makes us a bit uncomfortable!) you should know about.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
About SEHK:1720
Putian Communication Group
An investment holding company, produces and sells optical fiber cables, communication copper cables, and structured cabling system products under the Hanphy brand name in the People's Republic of China, Hong Kong, and internationally.
Slight with mediocre balance sheet.