Here's Why Eternity Technology Holdings (HKG:1725) Has A Meaningful Debt Burden

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. As with many other companies Eternity Technology Holdings Limited (HKG:1725) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Eternity Technology Holdings

What Is Eternity Technology Holdings's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Eternity Technology Holdings had CN¥26.7m of debt, an increase on CN¥16.4m, over one year. But on the other hand it also has CN¥179.0m in cash, leading to a CN¥152.3m net cash position.

How Healthy Is Eternity Technology Holdings' Balance Sheet?

The latest balance sheet data shows that Eternity Technology Holdings had liabilities of CN¥293.4m due within a year, and liabilities of CN¥32.0m falling due after that. Offsetting these obligations, it had cash of CN¥179.0m as well as receivables valued at CN¥112.1m due within 12 months. So its liabilities total CN¥34.4m more than the combination of its cash and short-term receivables.

Since publicly traded Eternity Technology Holdings shares are worth a total of CN¥505.5m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Eternity Technology Holdings boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Eternity Technology Holdings has seen its EBIT plunge 16% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Eternity Technology 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Eternity Technology Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Eternity Technology Holdings saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Eternity Technology Holdings has CN¥152.3m in net cash. So although we see some areas for improvement, we're not too worried about Eternity Technology Holdings's balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 5 warning signs we've spotted with Eternity Technology Holdings (including 1 which makes us a bit uncomfortable) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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