Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Chi Hua Fitness Co., Ltd. (GTSM:1593) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Chi Hua Fitness
What Is Chi Hua Fitness's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2020 Chi Hua Fitness had NT$93.7m of debt, an increase on NT$100.0k, over one year. But on the other hand it also has NT$525.0m in cash, leading to a NT$431.2m net cash position.
How Strong Is Chi Hua Fitness' Balance Sheet?
The latest balance sheet data shows that Chi Hua Fitness had liabilities of NT$238.0m due within a year, and liabilities of NT$101.4m falling due after that. Offsetting these obligations, it had cash of NT$525.0m as well as receivables valued at NT$237.9m due within 12 months. So it can boast NT$423.5m more liquid assets than total liabilities.
This surplus suggests that Chi Hua Fitness has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Succinctly put, Chi Hua Fitness boasts net cash, so it's fair to say it does not have a heavy debt load!
Chi Hua Fitness's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Chi Hua Fitness 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. While Chi Hua Fitness 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, Chi Hua Fitness generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
Summing up
While we empathize with investors who find debt concerning, you should keep in mind that Chi Hua Fitness has net cash of NT$431.2m, as well as more liquid assets than liabilities. The cherry on top was that in converted 89% of that EBIT to free cash flow, bringing in NT$77m. So we don't think Chi Hua Fitness's use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 3 warning signs with Chi Hua Fitness , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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About TPEX:1593
Excellent balance sheet slight.