Chi Hua Fitness (GTSM:1593) Has A Pretty Healthy Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Chi Hua Fitness Co., Ltd. (GTSM:1593) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Chi Hua Fitness

What Is Chi Hua Fitness's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Chi Hua Fitness had NT$94.2m of debt, an increase on none, over one year. But on the other hand it also has NT$403.4m in cash, leading to a NT$309.2m net cash position.

How Strong Is Chi Hua Fitness's Balance Sheet?

According to the last reported balance sheet, Chi Hua Fitness had liabilities of NT$289.1m due within 12 months, and liabilities of NT$5.11m due beyond 12 months. Offsetting these obligations, it had cash of NT$403.4m as well as receivables valued at NT$216.5m due within 12 months. So it actually has NT$325.7m more liquid assets than total liabilities.

This surplus suggests that Chi Hua Fitness is using debt in a way that is appears to be both safe and conservative. Given it has easily adequate short term liquidity, we don't think it will have any issues with its lenders. Simply put, the fact that Chi Hua Fitness has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Chi Hua Fitness has seen its EBIT plunge 13% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Chi Hua Fitness may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Chi Hua Fitness generated free cash flow amounting to a very robust 88% 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$309.2m, as well as more liquid assets than liabilities. And it impressed us with free cash flow of NT$90m, being 88% of its EBIT. So we don't think Chi Hua Fitness's use of debt is risky. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Chi Hua Fitness , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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