Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Eternity Technology Holdings Limited (HKG:1725) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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. 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. 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.
View our latest analysis for Eternity Technology Holdings
How Much Debt Does Eternity Technology Holdings Carry?
As you can see below, at the end of June 2019, Eternity Technology Holdings had CN¥17.3m of debt, up from CN¥12.7m a year ago. Click the image for more detail. But it also has CN¥150.6m in cash to offset that, meaning it has CN¥133.3m net cash.
How Strong Is Eternity Technology Holdings's Balance Sheet?
The latest balance sheet data shows that Eternity Technology Holdings had liabilities of CN¥207.9m due within a year, and liabilities of CN¥3.13m falling due after that. Offsetting these obligations, it had cash of CN¥150.6m as well as receivables valued at CN¥131.2m due within 12 months. So it actually has CN¥70.7m more liquid assets than total liabilities.
This surplus suggests that Eternity Technology Holdings is using debt in a way that is appears to be both safe and conservative. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Succinctly put, Eternity Technology Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Eternity Technology Holdings if management cannot prevent a repeat of the 28% 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. There's no doubt that we learn most about debt from the balance sheet. But it is Eternity Technology 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. Eternity Technology Holdings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Looking at the most recent three years, Eternity Technology Holdings recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Summing up
While it is always sensible to investigate a company's debt, in this case Eternity Technology Holdings has CN¥133.3m in net cash and a decent-looking balance sheet. So we are not troubled with Eternity Technology Holdings's debt use. Over time, share prices tend to follow earnings per share, so if you're interested in Eternity Technology Holdings, you may well want to click here to check an interactive graph of its earnings per share history.
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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