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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Dutech Holdings Limited (SGX:CZ4) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Dutech Holdings
What Is Dutech Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Dutech Holdings had debt of CN¥136.0m, up from CN¥191 in one year. However, it does have CN¥376.3m in cash offsetting this, leading to net cash of CN¥240.3m.
How Healthy Is Dutech Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Dutech Holdings had liabilities of CN¥516.3m due within 12 months and liabilities of CN¥176.5m due beyond that. Offsetting this, it had CN¥376.3m in cash and CN¥316.6m in receivables that were due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.
This state of affairs indicates that Dutech Holdings's 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 CN¥490.0m company is struggling for cash, we still think it's worth monitoring its balance sheet. Simply put, the fact that Dutech Holdings has more cash than debt is arguably a good indication that it can manage its debt safely.
On top of that, Dutech Holdings grew its EBIT by 87% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Dutech 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. While Dutech 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. In the last three years, Dutech Holdings's free cash flow amounted to 44% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Dutech Holdings has net cash of CN¥240.3m, as well as more liquid assets than liabilities. And it impressed us with its EBIT growth of 87% over the last year. So is Dutech Holdings's debt a risk? It doesn't seem so to us. 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. Case in point: We've spotted 4 warning signs for Dutech Holdings you should be aware of, and 1 of them doesn't sit too well with us.
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.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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