Is Computime Group (HKG:320) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 Computime Group Limited (HKG:320) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Computime Group

How Much Debt Does Computime Group Carry?

The image below, which you can click on for greater detail, shows that Computime Group had debt of HK$90.2m at the end of September 2021, a reduction from HK$116.8m over a year. However, it does have HK$405.8m in cash offsetting this, leading to net cash of HK$315.5m.

A Look At Computime Group's Liabilities

Zooming in on the latest balance sheet data, we can see that Computime Group had liabilities of HK$1.35b due within 12 months and liabilities of HK$67.3m due beyond that. Offsetting this, it had HK$405.8m in cash and HK$485.8m in receivables that were due within 12 months. So its liabilities total HK$525.8m more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of HK$800.4m, so it does suggest shareholders should keep an eye on Computime Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Computime Group boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Computime Group made a loss at the EBIT level, last year, it was also good to see that it generated HK$123m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is Computime 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Computime Group 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. Over the last year, Computime Group actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Summing up

While Computime Group does have more liabilities than liquid assets, it also has net cash of HK$315.5m. The cherry on top was that in converted 263% of that EBIT to free cash flow, bringing in HK$323m. So we don't have any problem with Computime Group's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Computime Group (including 1 which doesn't sit too well with us) .

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.