Huabang Technology Holdings (HKG:3638) Takes On Some Risk With Its Use Of Debt

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.' 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. As with many other companies Huabang Technology Holdings Limited (HKG:3638) makes use of debt. But the more important question is: how much risk is that debt creating?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Huabang Technology Holdings

How Much Debt Does Huabang Technology Holdings Carry?

You can click the graphic below for the historical numbers, but it shows that Huabang Technology Holdings had HK$122.9m of debt in March 2024, down from HK$173.1m, one year before. On the flip side, it has HK$72.1m in cash leading to net debt of about HK$50.8m.

How Strong Is Huabang Technology Holdings' Balance Sheet?

According to the last reported balance sheet, Huabang Technology Holdings had liabilities of HK$192.3m due within 12 months, and liabilities of HK$6.64m due beyond 12 months. Offsetting this, it had HK$72.1m in cash and HK$131.4m in receivables that were due within 12 months. So it can boast HK$4.60m more liquid assets than total liabilities.

This state of affairs indicates that Huabang Technology Holdings' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the HK$492.5m company is struggling for cash, we still think it's worth monitoring its balance sheet.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Even though Huabang Technology Holdings's debt is only 1.6, its interest cover is really very low at 1.9. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. We also note that Huabang Technology Holdings improved its EBIT from a last year's loss to a positive HK$22m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Huabang 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. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Huabang Technology Holdings recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

While Huabang Technology Holdings's conversion of EBIT to free cash flow makes us cautious about it, its track record of covering its interest expense with its EBIT is no better. But its not so bad at staying on top of its total liabilities. Looking at all the angles mentioned above, it does seem to us that Huabang Technology Holdings is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 3 warning signs for Huabang Technology Holdings (of which 1 doesn't sit too well with us!) you should know about.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com