Is Holy Stone EnterpriseLtd (TPE:3026) A Risky Investment?

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.' 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 can see that Holy Stone Enterprise Co.,Ltd. (TPE:3026) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Holy Stone EnterpriseLtd

How Much Debt Does Holy Stone EnterpriseLtd Carry?

The image below, which you can click on for greater detail, shows that at September 2020 Holy Stone EnterpriseLtd had debt of NT$2.13b, up from NT$1.11b in one year. However, it does have NT$4.19b in cash offsetting this, leading to net cash of NT$2.06b.

A Look At Holy Stone EnterpriseLtd's Liabilities

The latest balance sheet data shows that Holy Stone EnterpriseLtd had liabilities of NT$3.87b due within a year, and liabilities of NT$614.7m falling due after that. Offsetting this, it had NT$4.19b in cash and NT$3.44b in receivables that were due within 12 months. So it actually has NT$3.15b more liquid assets than total liabilities.

It's good to see that Holy Stone EnterpriseLtd 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 Holy Stone EnterpriseLtd has more cash than debt is arguably a good indication that it can manage its debt safely.

But the bad news is that Holy Stone EnterpriseLtd has seen its EBIT plunge 17% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Holy Stone EnterpriseLtd's earnings that will influence how the balance sheet holds up in the future. 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 Holy Stone EnterpriseLtd 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. Looking at the most recent three years, Holy Stone EnterpriseLtd recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Summing up

While it is always sensible to investigate a company's debt, in this case Holy Stone EnterpriseLtd has NT$2.06b in net cash and a decent-looking balance sheet. So we don't have any problem with Holy Stone EnterpriseLtd's use of debt. 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 1 warning sign with Holy Stone EnterpriseLtd , and understanding them should be part of your investment process.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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. 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.
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