Is Putian Communication Group (HKG:1720) 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. Importantly, Putian Communication Group Limited (HKG:1720) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Putian Communication Group

What Is Putian Communication Group's Debt?

You can click the graphic below for the historical numbers, but it shows that Putian Communication Group had CN¥212.4m of debt in December 2020, down from CN¥223.6m, one year before. However, it does have CN¥112.0m in cash offsetting this, leading to net debt of about CN¥100.4m.

How Strong Is Putian Communication Group's Balance Sheet?

The latest balance sheet data shows that Putian Communication Group had liabilities of CN¥237.3m due within a year, and liabilities of CN¥100.4m falling due after that. Offsetting this, it had CN¥112.0m in cash and CN¥250.4m in receivables that were due within 12 months. So it can boast CN¥24.7m more liquid assets than total liabilities.

This short term liquidity is a sign that Putian Communication Group could probably pay off its debt with ease, as its balance sheet is far from stretched.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Putian Communication Group's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 17.2 times its interest expense, implies the debt load is as light as a peacock feather. The modesty of its debt load may become crucial for Putian Communication Group if management cannot prevent a repeat of the 54% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Putian Communication Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Putian Communication Group's EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Putian Communication Group is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 4 warning signs for Putian Communication Group (1 is a bit concerning!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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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