Is Rich Honour International Designs (TPE:6754) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Rich Honour International Designs Co., Ltd. (TPE:6754) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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 Rich Honour International Designs

How Much Debt Does Rich Honour International Designs Carry?

As you can see below, Rich Honour International Designs had NT$213.6m of debt at September 2020, down from NT$375.6m a year prior. However, it does have NT$1.14b in cash offsetting this, leading to net cash of NT$929.2m.

How Strong Is Rich Honour International Designs' Balance Sheet?

We can see from the most recent balance sheet that Rich Honour International Designs had liabilities of NT$1.50b falling due within a year, and liabilities of NT$359.0m due beyond that. Offsetting these obligations, it had cash of NT$1.14b as well as receivables valued at NT$1.28b due within 12 months. So it actually has NT$568.2m more liquid assets than total liabilities.

It's good to see that Rich Honour International Designs has plenty of liquidity on its balance sheet, suggesting conservative management of liabilities. Because it has plenty of assets, it is unlikely to have trouble with its lenders. Simply put, the fact that Rich Honour International Designs has more cash than debt is arguably a good indication that it can manage its debt safely.

It is just as well that Rich Honour International Designs's load is not too heavy, because its EBIT was down 22% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Rich Honour International Designs 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Rich Honour International Designs 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. During the last three years, Rich Honour International Designs generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While it is always sensible to investigate a company's debt, in this case Rich Honour International Designs has NT$929.2m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 95% of that EBIT to free cash flow, bringing in NT$362m. So is Rich Honour International Designs'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. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Rich Honour International Designs is showing 3 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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