Does VSTECS Holdings (HKG:856) Have A Healthy Balance Sheet?

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 VSTECS Holdings Limited (HKG:856) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for VSTECS Holdings

What Is VSTECS Holdings's Net Debt?

The chart below, which you can click on for greater detail, shows that VSTECS Holdings had HK$8.10b in debt in December 2023; about the same as the year before. However, it does have HK$4.75b in cash offsetting this, leading to net debt of about HK$3.35b.

How Strong Is VSTECS Holdings' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that VSTECS Holdings had liabilities of HK$26.6b due within 12 months and liabilities of HK$241.4m due beyond that. Offsetting this, it had HK$4.75b in cash and HK$16.8b in receivables that were due within 12 months. So it has liabilities totalling HK$5.22b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of HK$6.87b, so it does suggest shareholders should keep an eye on VSTECS Holdings' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

VSTECS Holdings has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.2 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We saw VSTECS Holdings grow its EBIT by 8.9% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine VSTECS Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, VSTECS Holdings reported free cash flow worth 16% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

At the end of the day, we're far from enamoured with VSTECS Holdings's ability to convert EBIT to free cash flow or to handle its total liabilities. But the silver lining is its relatively strong EBIT growth rate. Once we consider all the factors above, together, it seems to us that VSTECS Holdings's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that VSTECS Holdings is showing 2 warning signs in our investment analysis , 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.

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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.