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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. Importantly, Changhong Jiahua Holdings Limited (HKG:3991) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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.
Check out our latest analysis for Changhong Jiahua Holdings
What Is Changhong Jiahua Holdings's Net Debt?
As you can see below, at the end of December 2019, Changhong Jiahua Holdings had HK$1.01b of debt, up from HK$880.5m a year ago. Click the image for more detail. But on the other hand it also has HK$1.09b in cash, leading to a HK$87.5m net cash position.
How Healthy Is Changhong Jiahua Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Changhong Jiahua Holdings had liabilities of HK$5.38b due within 12 months and liabilities of HK$2.03m due beyond that. Offsetting this, it had HK$1.09b in cash and HK$2.11b in receivables that were due within 12 months. So it has liabilities totalling HK$2.18b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's HK$1.98b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price. Given that Changhong Jiahua Holdings has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
One way Changhong Jiahua Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 18%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Changhong Jiahua Holdings 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.